This article explains the pros and cons of starting a new biz as a limited liability company or as a corporation.
Despite what a famous business personality keeps saying, an LLC is NOT ALWAYS the best form of incorporation.
Spoiler alert - here’s another graphic showing how the key tax, ownership, fundraising, and governance considerations often shake out in practice.
With any luck, this graphic has what you're looking for and you can go back to something interesting.
If not, this article is structured for efficiency so you can get the answer you need and move on with your life. Here we go.
Seeking VC or Angel Funding?
Form a corporation, not an LLC.
VCs do not invest in LLCs, they invest in corporations, preferably Delaware corporations. This is because many investors in VC funds cannot invest in companies with partnership/pass-through taxation. The name for this barrier is Unrelated Business Taxable Income, or UBTI.
Many investors in VC funds are tax-exempt entities and cannot be deemed to have received income from unrelated business activities. Unlike corporations, LLCs are taxed as partnerships, meaning the income of LLCs is deemed to flow through directly to the owners.
In addition to the UBTI issue, there's the matter of tax complexity. Owning shares of stock in a corporation has no tax implications (or filings) until dividends are received or the stock is sold. One of my CFO buddies received equity compensation in the form of LLC units. He files annual Form K-1 tax returns in nine states where the company does business, lol....
Sophisticated angel investors, including angel groups, are less likely to be barred from receiving UBTI, but are still likely to favor corporations over LLCs for tax reasons and for reasons discussed later regarding legal certainty and commonly understood governance structures.
It is possible to create what is called a "blocking corporation" structure to allow VCs to invest indirectly in an LLC. In this structure, a corporation owns the LLC and all investment occurs at the parent corporation level. Many view such structures with suspicion, though, if for no other reasons, for their cost and complexity.
Here's a good article on UBTI and LLC tax complexity - The Choice of Entity Decision for VC Financed Start-ups
Will Founders Take Cash Out?
Form an LLC, not a corporation.
If the business is a typical small business or "lifestyle company," and a primary purpose is to generate cash for the owners, "partnership taxation" is the goal, and hence LLC formation. LLCs are "disregarded entities" for tax purposes, and this status prevents the dreaded "double taxation" that occurs with corporations.
This is because payments to shareholders of corporations, called dividends, are taxable at the recipient's tax rate, even though the corporation already paid income tax on those same dollars.
Therefore, most small businesses, lifestyle companies, consultancies, and many bootstrapped companies tend to be formed as LLCs.
An alternative worth noting here is that founders can elect for a corporation to be taxed like a partnership by making an "S Corp election." An S Corp election eliminates the double taxation risk and also allows the owners to net early startup losses against other income, where allowed under the tax code.
There are only three requirements for S Corp status: (i) fewer than 100 shareholders, (ii) only one class of stock, and (iii) no foreign investors.
But note, most tech startups are managed for growth toward a sale or IPO and do not issue dividends. Thus, double taxation is not an issue. That is, unless there will be significant asset sales, as discussed later.
Here's an excellent article by Cooley comparing C Corps, S Corps, and LLCs - Comparison of C Corp, S Corp and LLC Entity Types.
Section 1202 - Tax-Free Founders Stock - QSBS
Do the founders want to pay no capital gains tax on up to $10M of gain on the sale of their investment in a tech startup held for five years?
Form a corporation.
Internal Revenue Code Section 1202 lets investors (including founders) avoid up to $10M of capital gains tax if they hold early startup stock for five years.
Here's an article on Section 1202 and QSBS - The QSBS Tax Exemption: A Valuable Benefit for Startup Entrepreneurs.
Tax strategies almost always factor into a decision to form an LLC.
But early advantages, such as harvesting losses to offset other income, should be analyzed against the ability to avoid capital gains tax on the sale of stock.
To be clear, Section 1202 does not apply to LLCs. Even if someone says otherwise.
If an LLC later converts to a corporation, that's when the five-year clock starts. So the idea of starting as an LLC and later converting to a corporation is not without tax risks.
Likelihood of Significant Asset Sales
If a business is likely to be involved in significant asset sales, form an LLC.
This is a complex and highly tax-driven topic, but for a variety of reasons, including avoidance of double taxation on asset sales, tax advisors often strongly recommend that businesses focused on property or asset development or accumulation be formed as LLCs.
Among other reasons, the sale of assets to a third party or the distribution of assets to owners would result in double taxation if the business is structured as a corporation, but not if structured as an LLC.
Here's an article that goes into the complexities of property ownership and development, many of which likely carry over to the sale of other appreciated assets - Using LLCs for Real Estate Investment.
Other Tax Strategies
There are several other LLC-enabled tax strategies worth noting that require consultation with tax experts.
First, LLCs (and likely S Corps) are often used to reduce payroll tax liabilities by paying owners more modest salaries and relying on tax-free distributions to get larger amounts of available cash to the owners. Salaries are subject to payroll taxes, distributions are not. But there are limitations and rules to understand.
Secondly, owners of LLCs and partnerships can agree to make certain "special allocations" allowing specified owners to be allocated technically disproportionate interests in items of income, gain, loss, deduction, or credit. Special allocations are limited by what the IRS calls the "Substantial Economic Effect" test, and are not to be solely driven by the desire to reduce tax obligations. Or, as the following article puts it:
"The principle of Substantial Economic Effect is a litmus test the Internal Revenue Service (IRS) applies to ensure that the allocation of income, losses, deductions, and credits among partners is not merely an artificial arrangement for tax purposes, but instead reflects the genuine economic arrangement between the partners."
Thirdly, LLCs are used for sophisticated wealth management strategies, including the gifting of LLC interests to family members in lower tax brackets to facilitate tax-free distributions for the maintenance, education, or support of those family members.
Distributing LLC interests to lower-income family members reduces the family's overall tax burden from the LLC's business activities.
Management and Governance Dominance
Is absolute management and governance dominance important?
Form an LLC.
In any situation where one or more persons, including a private equity (PE) firm, wish to have absolute and undisputed control over a business, an LLC Operating Agreement can be drafted to accomplish that.
This is because LLCs are generally creatures of contract and corporations have long been considered creatures of statute and case law, with contractual governance provisions being limited by corporate law principles, primarily fiduciary duties.
In fact, both DE and NY have recently created case law saying essentially that all LLCs formed under their laws can waive all fiduciary duties in LLC Operating Agreements.
Unlike in a corporation, which has a board-shareholder-officer hierarchy under applicable statutes and case law, any ownership and control relationship can be negotiated by the owners of an LLC.
I noted in a recent article that the Delaware legislature has taken DE corporate law much further in this direction in 2024 at the behest of PE firms, but hopefully VCs will be slow to take advantage of these new DE powers.
In any event, potentially absolute governance powers are one reason sophisticated angel investors, PE firms, and others might shy away from taking a minority interest in an LLC - i.e., the risk that majority owners can abuse the interests of minority owners.
Low Cost of Formation
Do you have no money to form a company with two or more founders?
Form a corporation.
You can use a sophisticated site like www.cooleygo.com to create an entire Delaware incorporation package for free with some nominal legal guidance or you can generally pay a law firm $5K to $10K to form an LLC with a properly negotiated and drafted Operating Agreement.
Stated more succinctly, you can form a properly organized corporation with a board, officers, and shareholders at relatively low cost, but you generally cannot negotiate and draft a proper LLC Operating Agreement without spending thousands of dollars.
Hopefully the LegalTech sector and AI-savvy lawyers will soon solve this problem of inaccessibly expensive Operating Agreements.
The attorneys at Foundry Law have launched a service purporting to offer low-cost operating agreements for Washington LLCs - Washington State LLC Builder For Multi-Member LLCs.
And attorney Brian Heller says his firm, Outside GC, can get the cost down to $1K or $2K. Here's his article on the process - How to Create an LLC Operating Agreement.
A founder group thinking they can form an LLC with little or nothing out-of-picket and then negotiate and pay for a full-blown Operating Agreement later when they have more money could be in for a rude awakening when they realize their LLC is governed by counter-intuitive state "default rules" that fill in gaps created by a non-existent or deficient Operating Agreement.
In general, all owners of an LLC with no Operating Agreement are equal owners with equal claims to profits and equal authority to bind the LLC to contracts and other obligations, notwithstanding their otherwise unequal investments or contributions.
For more on state default rules, check out this article - "Don't Leave Your LLC at the Mercy of Default State Law Provisions."
Plan to Issue Stock Options?
Form a corporation.
LLCs cannot and do not issue "stock options." Only corporations issue stock options.
And the U.S. tax code provides beneficial tax treatment for holders of what are called incentive stock options (ISOs), but not for holders of equity compensation in LLCs.
Instead of issuing stock options, LLCs must spend lots of money on outside specialists developing more complex and opaque incentive plans if they wish to incentivize employees, board members, or service providers with equity grants.
LLC equity incentive plans are more complex because there are substantially greater tax implications to becoming an owner of an LLC than becoming a shareholder of a corporation and there is no relief whatsoever from these implications under the tax code.
Thus, LLC equity incentive plans take the form of more exotic and complex interests, such as phantom membership units, profits interests, revenue participation interests, and interests going by other exotic names.
In addition to these plans being more complex and expensive, they might also be less inspiring to employees, directors, and service providers, as they are usually more opaque than traditional stock options, restricted stock awards, or even stock appreciation rights.
Here's an article explaining the complexities of LLC equity incentive plans - Equity Incentives in Limited Liability Companies (LLCs).
IPO
Planning to go public? Form a corporation.
For all practical purposes, only corporations go public. No LLC ever went public. This means that for an LLC to go public, it would need to be converted to a corporation.
Entity conversion is relatively simple early in a company's existence, but becomes increasingly more complex depending on its capitalization, operating history, and tax status. Converting a company with a substantial operating history could require tens of thousands of dollars of tax and legal work and difficult negotiations to convert non-standard LLC ownership units into corresponding stock ownership interests.
In addition to those concerns, remember that the five-year holding period for capital gains tax relief under Section 1202 would only begin at the time of conversion, meaning that sales of shares in an IPO might be subject to full capital gains tax.
Legal Certainty
Are you forming a startup with others and do you find legal disputes daunting and intimidating?
Form a corporation.
Modern corporation laws go back to the late 1880s. Modern LLC laws go back to the 1970s.
Without belaboring the point, the law of corporations is vastly more settled than the law of LLCs. When judicially created "case law" is less settled, disputes are likely to be more common, more expensive to resolve, and less predictable.
In my anecdotal experience, LLCs are more likely to devolve into disputes between and among the founders and the company and to take longer to resolve, whether favorably or unfavorably. On several occasions, I have found that key issues in disputes involving LLCs were "matters of first impression" under the state's case law. Not good.
The concern about legal certainty should not trump compelling reasons for forming an LLC, like the avoidance of double taxation on anticipated distributions to owners and/or anticipated asset sales.
But where tax considerations are less clear or less material, many sophisticated investors prefer the greater legal certainty and predictability of corporations over LLCs.
For founders going the LLC route, working with counsel to have a very well-considered Operating Agreement ready to sign at entity formation is the first line of defense against disputes. Plan on spending at least $5K to $10K barring low-priced offerings in your preferred state of formation.
Summary
Most tech startups that plan to focus on growth, reinvest all revenues into the company, and seek VC funding should be formed as corporations from inception. This avoids the costs and complexities of an LLC to corp conversion and starts the Section 1202 five-year clock as soon as shares are issued.
Businesses that are more likely to be treated as typical small businesses or lifestyle companies, including consultancies, are often best off as LLCs, or perhaps as C corporations. Note that consultancies are excluded from the benefits of Section 1202, unfortunately, but many types of small businesses and lifestyle companies are not, so an S Corp can preserve Section 1202 status where appropriate.
Further, the possibility of significant asset sales can be another important factor in favor of forming an LLC or opting for S Corp status.
And none of this is legal, financial, or tax advice, so consult personal advisors, particularly where legal or tax complexities are likely.
Paul Swegle, editor of the StartupGC Blog, serves as in-house chief legal officer/general counsel to numerous tech companies and has advised countless others. He has completed $18+ billion of financings and M&A deals, including growing and selling startups to public companies ING, Capital One, Nortek, and Abbott. Paul teaches entrepreneurship law at Gonzaga Law and Seattle University School of Law and speaks regularly at other top law schools and MBA schools where his popular business law books are widely used in courses focused on entrepreneurship and business law.
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