| p>As promised, here is the follow-up question | | | | The biggest limitation of LLCs, in my experience, is the |
| submitted by Jon who is debating the merits of | | | | very limited nature of how you deal with the ownership |
| selecting an LLC or a C-Corporation or an | | | | structure. LLCs do not have shareholders and shares |
| S-Corporation, as well as wondering where to setup | | | | of stock, they have "members" and "units" |
| such an organization. | | | | (nomenclature that is sure to make any fan of 9th |
| In general, I would lean to forming an LLC because it's | | | | grade humor to laugh uncontrollably). On the surface, it |
| very easy to setup, you can do it yourself, and the | | | | may seem that these are just different names for the |
| fees for setting it up (not counting California) are pretty | | | | same thing, but that's not the case. |
| inexpensive. You gain the limited liability that you need, | | | | In an LLC, one member is the same as another |
| and you get pass through accounting for profits and | | | | member. Everyone is working under the same |
| losses without the "double taxation" you have with a | | | | operating agreement, and if I have 100 units, and you |
| C-Corporation. | | | | have 100 units, there is no difference between us. An |
| Sounds great, right? Well in most cases, it is, and this is | | | | investor, the owner, other employees who have been |
| is why you see so many businesses setup as LLCs | | | | given ownership -- all these people hold exactly the |
| today. My first business was an S-Corp, which offered | | | | same type of equity, the unit, and there is no |
| many of the same benefits, but this was before LLCs | | | | difference between them. There is only one kind of |
| even existed. Since then, all of my businesses have | | | | unit in an LLC, and that's that. |
| started as LLCs. As they grew, they changed to | | | | C-Corporations are very different. C-Corporations can |
| C-Corporations for reasons I'll explain below. | | | | issue different classes of stock, so an investor might |
| Jon writes: | | | | have preferred stock, employees and owners |
| First off, I guess for what type of entity to setup the | | | | common stock. Those classes can be subdivided |
| main issue I had originally was whether to be an S | | | | further so a investor today might get "Series A |
| corp or LLC. It seems those 2 would be the best | | | | Preferred Stock" with certain rights and privileges, and |
| ways to go for my buddy as far as protecting his | | | | a later investors get "Series B Preferred Stock" with |
| personal assets and the pass through taxation. LLC | | | | different rights, etc. You might setup a stock option |
| seems a bit more flexible than S corp, but the LLC has | | | | plan for employees to give them ownership in |
| to pay SE taxes, where I think the S corp either | | | | exchange for their work and loyalty to the company, |
| doesn't (or gets to deduct them). Both LLC and S corp | | | | while the owners have common stock, perhaps with a |
| avoid the double taxation that a C corp would bring on, | | | | founders stock agreement as described in an earlier |
| right? | | | | question. Vendors might get warrants in exchange for |
| LLCs vs. S-Corporations | | | | providing discounted services. |
| S-Corporations are subject to many of the same | | | | In short, there is a lot more flexibility here. Also, there |
| record keeping and procedural requirements as | | | | are tax implications. Because an LLC has one kind of |
| C-Corporations, which is probably something you don't | | | | unit, the tax is very simple, and perhaps, not very |
| want to mess around with. Likewise, there are also | | | | helpful. If an investor puts in money at $10 / unit, and |
| limitations on how you share profits and losses among | | | | you then give away 100 units to an employee because |
| the shareholders. You probably don't want to mess | | | | you want to give them ownership, then you've just |
| with that, and LLCs allow you to avoid all that | | | | subjected that employee to a tax hit. The IRS will say |
| paperwork, and to split profits and losses however | | | | that you "gave" the employee $1000 worth of stuff |
| your LLC Operating Agreement dictates, regardless of | | | | ($10 * 100 units), and they'll owe income tax, at ordinary |
| actual shares held. | | | | income levels, on that gain. So now your good |
| There are situations where you would want an | | | | intentions just cost your employee $300+ in taxes. |
| S-Corp over an LLC, but those are somewhat rare | | | | They probably won't like that. So they can either shell |
| and I've never seen a recent startup need to setup | | | | out $1000 for the units (fair market value), or you can |
| that way. Here again, an attorney might have good | | | | give them cash along with the units (which they'll also |
| advice, but I'll say with pretty high confidence that an | | | | have to pay tax on), so that they can use that cash to |
| LLC is the way to go over an S-Corp for a startup. | | | | pay for the tax on the units you gave them. Especially |
| Now LLC vs. C-Corporation is a different matter, and | | | | when you talk about bringing in management team |
| might warrant some consideration... | | | | members, who might demand big pieces of ownership, |
| LLCs vs. C-Corporations | | | | you quickly can have yourself a real mess. |
| The most obvious problem with C-Corporations is that | | | | In the C-Corp, you are probably going to create a |
| they do not offer the pass through accounting that | | | | stock option plan, and use that to give ownership to |
| LLCs (or S-Corps) do, meaning that the Corporation | | | | employees. So long as the option price is equal to the |
| will pay tax on any profits it has, the owner will be paid | | | | fair market value of the underlying class of stock - at |
| with a salary just like any other employee, on which | | | | the time the option was granted - there is not taxable |
| they will pay taxes, and if you make profit distributions | | | | event. The expectation is that the company will grow, |
| (by means of dividends), the shareholders will be taxed | | | | and by the time the employee vests the stock, it will |
| on that as well. I could easily climb on my soapbox and | | | | be worth a lot more than it was when it was granted. |
| complain how taxation of dividends is double taxation | | | | The employee will then have to pay tax on the gain if |
| on the exact same income, and how it leads | | | | and when they exercise those options, but normally |
| corporations to make decisions that are not in the best | | | | they don't exercise until they intend to cash in those |
| interest of shareholders, and how it encourages | | | | options, and so they are simply paying tax on actual |
| gigantic, multi-national, and anti-competitive business | | | | cash they just received, and everyone is happy. It's |
| evolution rather than profitable, innovative, smaller | | | | short term capital gain and not long term capital gain, |
| entities... but THAT is for another day (and probably | | | | but when you sell to Google for a cool billion, everyone |
| another blog entirely!) | | | | will be pleased. |
| But, suffice it to say that the tax code is not friendly to | | | | A fine point in this is to understand that, in a |
| the C-Corporation that wants to operate and then | | | | C-Corporation, all classes of stock are not created |
| provide profits to the shareholders. If those | | | | equal, and therefore, are not priced the same. Just |
| shareholders also work there, then are three different | | | | because an investor buys preferred shares at $10 |
| points of taxation. LLCs look like they have only one, | | | | share does not at all mean that your common shares |
| but in reality there is a secret second point of taxation | | | | are also worth $10/share or that your base option |
| because you have to pay self-employment tax in | | | | price is therefore $10/share. The preferred shares |
| addition to income tax. Don't you love how the | | | | have all kinds of things that make them more valuable, |
| government tries really hard to discourage people from | | | | and no knowledgeable person would pay $10 for |
| working for themselves in the tax code, while paying lip | | | | common when the same $10 gets them a whole lot |
| service to how small business drives the economy? | | | | more with preferred. The board of directors will set |
| Ah, there I go again... | | | | the price of common, noted in the minutes, with an |
| Anyway, paying self employment tax is still (most | | | | explanation of why it's so much less than the |
| likely) cheaper than the C-Corp tax, because when | | | | preferred shares. It's not uncommon for this discount to |
| you are paid as an employee, the C-Corp will need to | | | | be 90% (or more) in a new startup, so a $10 preferred |
| make an employment tax withholding on your salary | | | | price might mean $1 (or less) for common shares and |
| which is essentially the same as the self employment | | | | thus option exercise price. |
| tax. One difference is that with the C-Corp, you might | | | | Summary |
| well hold profits in the corporation rather than pay | | | | What's it all mean? Well, here's what I do: When I |
| them out, so if you were going to be highly profitable, | | | | setup a new company, either on my own or with |
| you might be better served to hold profits there (and | | | | partners, we setup an LLC. At the point that we need |
| avoiding, for a while, the extra taxation) while paying | | | | to start dolling out stock options in order to hire more |
| yourself a minimal salary. | | | | people, or that we need to bring in outside investors, |
| Now in a company that's going to experience a period | | | | we convert to a C-Corporation. When you're talking |
| of losses as things ramp up, the LLC has advantages | | | | investors and employee option pools, C-Corporations |
| to the owner-operator. LLCs will pass those losses | | | | are the way to go. If it's just you and some partners |
| along, and those loses can offset other income the | | | | trying to make a few bucks, go with the LLC. |
| individual might have. In a C-corp, the corporation will | | | | If you are only going to raise a little money and never |
| carry those losses (for credit against future profits), but | | | | any more, then you can do that with an LLC, but be |
| the owner-operator, who is an employee, does not get | | | | careful: the last thing you need is a big group of |
| to take those losses. They will have W-2 income and | | | | investors, who put money in at all different times in the |
| will be taxed accordingly, just as they would if they | | | | company's life, with no real distinction or flexibility in |
| were an employee at McDonalds or anyplace else. | | | | how those shares/units work. |
| So ready to jump right in as an LLC? Not so fast -- | | | | Additional information, links to legal assistance, and |
| there are a few more considerations... | | | | other resources are available at my blog, McStartup. |