Now that all 50 states allow startup entrepreneurs to organize their new businesses as Limited Liability Companies (“LLC”), I routinely receive questions from entrepreneurs who want to know, “Which legal structure is better – a corporation or an LLC?”
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While no single strategy is right for every business situation, LLCs offer significant advantages to new business owners in terms of administration. Unlike corporations, LLC organizers are not statutorily required to hold meetings of its member owners, keep meeting minutes, or faithfully prepare formal written resolutions to issue new company stock, acquire assets, open bank accounts or make big changes in the company’s business direction. Entrepreneurs who know they won’t keep good records by themselves or hire someone who will, should favor an LLC organization.
What’s confusing about LLCs is the terminology. Whereas investors in corporations are called “stockholders;” investors in LLCs are called “members.”
Corporations are governed by documents called articles of incorporation and bylaws and LLCs are governed by, in most states, its articles of organization and its operating agreement.
An LLC business structure is also a common favorite among real estate developers and film producers. LLCs allow developers an easy way to involve different investors in different projects. Also, there are certain tax benefits for holders of real estate that are expected to appreciate in value. Even better, real estate developers who spend the majority of their time in the real estate profession and are active in the management of the properties can usually write off real estate losses against other forms of income without limitation.
Here are some other key differences between corporations and LLCs:
-Tax rates and obligations. An LLC allows business profits to bypass traditional corporate taxes and “pass through” to the LLC’s members. Members then report their LLC-related income or losses on their personal income tax return.
In contrast, business profits in a standard C corporation are taxed by the federal government and again by most states. Then to the extent that shareholders take out the profits in the form of dividends or bonuses, Uncle Sam gets paid once again. Owners of C corporations can receive the same tax bypass benefits of LLCs only if they qualify and elect S-corporation tax status with the IRS.
-Personal liability. LLC’s and C and S corporations provide owners with some limitations of liability. If, for example, a business obtains a bank loan without signing a personal guarantee, shareholders and company managers would generally not be personally liability for missed payments. It’s important to note that exceptions to liability limitations may exist in tort claims involving negligence or fraud.
-Equity fundraising. Big concept entrepreneurs seeking angel or venture funding should favor organizing as a C corporation. Multiple rounds of venture funding often involve the issuance of several classes of common and preferred stock – which is easily handled in a C corporation structure. Many sophisticated investors crinkle their noses at LLC’s and won’t invest until the structure is changed – at the entrepreneur’s expense. Employee stock options are also easily administered in C corporations.
The second most common question entrepreneurs ask me about LLC organizations is if they need an attorney. I typically encourage first-time entrepreneurs to hire a competent business attorney instead of buying do-it-yourself LLC organization kits. Sure, hiring an attorney may sound intimidating or costly, but entrepreneurs are never well served by penny pinching on potentially big dollar issues.
Each state has varying rules for LLC fees and formation. For example, some states don’t allow single member limited liability companies which rules out many freelance entrepreneurs who want to shield their personal assets from business calamities.
Attorneys can be skilled advisors and mediators as new business partners’ work through the details of their LLC’s operating agreement. At its best, this agreement should carefully define voting rights, responsibilities of the business partners, the procedures for buying or selling member shares in the business, or even how to one day dissolve the business.
Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship. She is the founder of www.takecommand.org, a community service organization that boasts of offering the largest centralized database of startup and small business funding sources in the U.S. Ask Susan your questions at firstname.lastname@example.org