A Rich Man's Dilemma: LLC or Inc.?

The prevailing wisdom on the matter of entity choice is that if you're a start-up you should organize as a corporation (either a C or an S). FN1 And if you reasonably anticipate seed or venture financing at any time in the future, this is eminently sensible.FN2 

The more relevant question is whether the LLC is the preferred entity form in all other scenarios, at least given extant tax law and related legal and business trends. The answer is: yeah, mostly, or at least, probably, depending. Wishy-washy guidance, maybe, but that's how to stay clean, for sure.

If you're a small business without much revenue, employees or any partners you might not even need to formally organize. LLCs and corporations are desirable entity forms principally because they protect you from exposure to personal liability for actions you take in the capacity of an agent for the business. If a partner or employee commits a tort in the course of providing services then the entity form prevents an injured party from suing you personally. Similarly, if the company takes a loan and can't pay it back then the creditor can't go maraud your personal bank account. FN3

The LLC then is the preferred entity form for company that has growth potential but is not anticipating seed or venture financing (the most obvious example here is a consulting business). The rationale is pretty basic: an LLC has limited liability protection but a) "partnership-style" pass through taxation (whereby taxes flow straight through to LLC members - rather than to the corporate form first and then to shareholders (creating the so-called "double taxation")); FN3 and b) partnership-style flexibility in terms of organizational form (e.g., no need to record every major decision or hold formal meetings, the capacity for special allocations of profits (not according to percentage ownership), etc.).

In addition, it can be mentioned that LLC's have lower statutory compliance costs (in terms of paperwork, corporate fees, etc. filed with the government) and that's technically true (regardless of the state in which the LLC was formed) but also somewhat misleading since the expense difference is probably just going to be a few hundred dollars here and there. Along these lines although it's said a corporation is more complex (bureaucratically) to initially create than an LLC, the difference is about the same as renewing a motorcycle license versus renewing a car license. Either way you have to go to the DMV and independent of the specifics that's the real hassle.

The core problems for an LLC are a) raising funds and b) hiring/managing employees. Once an LLC grows to a certain size and the partners seek to raise money through outside investment or delegate work to individuals it will start to shoe-horn corporation-like terms into its documents. The first problem is unavoidable and if you're a classic start up with big ambitions, it might make sense to incorporate as per FN1. 

The second problem (employee management), however, is becoming increasingly manageable. Traditionally, incentivizing LLC employees was difficult because the portion of the IRS code which applies to employee stock option plans is solely relevant to corporations. Recent regulations, however, enable an LLC to efficiently grant "profits interests" to employees, which in effect act as stock appreciation rights (the logistics of such a grant are discussed here).

In addition, as far as the IRS is concerned, all LLC members are partners. Which means any employees of the LLC that receive equity won't be receiving W-2s and are subject to self-employment tax on income (at a rate of around 15% percent) rather than a share of FICA (at a rate of 7.65 percent) (as is the corporate case). This can vitiate the incentive of the equity (which is why LLCs commonly pay employees (who have equity in the LLC) a proportionally higher salary to compensate for the increased taxes).

Such are the high level variables that inform choice of entity. In the end, this is chiefly a question of tax strategy, so consult with your accountant. 

FN1. A brief note here on the S Corp. An S Corp is (essentially, for the purposes of this discussion) like a C Corp except it has the benefit of flow through tax treatment (no double taxation). It's purpose is limited since it has limitations with respect to who can hold its stock (no entities and non non-U.S. citizens), among other things. An S Corp makes sense when the founders anticipate a future financing but also expect to personally fund the initial losses until that point in time and want to deduct those losses on their individual tax returns (i.e., pass through income tax treatment). Transitioning from an S Corp to a C Corp is relatively cheap and easy (for example, upon the event of funding from a VC, an S corporation will automatically convert to a C corporation). A very coherent and comprehensive comparison of the LLC and the S Corp is here.

FN2: There's plenty of commentary on on why this is the case in the blogosphere. A good summary is here. In short, an anticipated financing event (whereby the company is raising capital from outside investors) demands a corporate form because that's the way investors and lawyers are used to doing it. The LLC is a relatively new entity type (it wasn't really a tenable option until the late 1980s) and thus the investment community (and pretty much anyone involved in transacting financings (lawyers, accountants, etc.)) is not conditioned to working with anything but the corporate form (nor comfortable since there isn't a comparably established and uniform set of rules and regulations for LLCs). Thus, an LLC seeking to raise outside capital will, even if it finds investors interested in their business plan/product, almost inevitably a) be required to re-organize as a corporation (and this requires lawyers and if the company has any operational complexity at all can be expensive) as a condition to the financing, b) encounter significant documentation, legal and accounting costs (since all the standard templates for purchase agreements, investor rights agreements, term sheets, etc. are geared for the corporate form), and/or c) create more exposure to unanticipated costs (documentation mistakes, etc. that need to be corrected) and legal risks because of there's less guidance and standardization.


FN3. The limitation of liability that attaches to the corporate or LLC entity can be undone if it's shown, however, that a company owner provided a personal guarantee on the loan or commingled personal with company funds or otherwise did not adequately treat the company as separate from himself.

Think Evil, and Early

The movie The Social Network takes place in a conference room, presumably at a law firm. Mark Zuckerberg and his lawyers sit across from Zuckerberg's former business partner and his lawyers and through flashbacks we learn how they ended up there. It's a clever narrative device and a post-worthy lesson for founders: in the best case scenario, maybe especially in the best case scenario - the company wildly succeeds - there may be disputes between the founders as to the distribution of that success.

Co-founders sue in bad case scenarios too. And medium case scenarios, I suppose. This is America. And, frankly, they might even have an understandable argument and claim. It might not even be them. It might be their son or widower or soon to be ex-spouse. 

There's an obvious enough strategy to eschew the worst of this: document partner rights, responsibilities and distribution rules (in the event of a break-up) at the outset. This is frequently not done, or done with enough care, for all the reasons you'd suspect. Timing wise, the outset is an unlikely and also awkward moment to consider the dissolution of the partnership.

Ironically, doing the necessary documentation here is not a particularly onerous exercise. It probably does not even necessarily require a lawyer. It is simply a matter of drafting provisions into some operative agreement (usually the Bylaws (if you're a corporation) or the Operating Agreement (if you're an LLC) or otherwise some kind of partnership agreement if the partnership is some other form).

The provisions in that operative agreement (even if your attorney does the drafting, make sure these issues are addressed) should memorialize in detail: a) the time or capital (as is relevant) each founder is expected to contribute, b) what percentage of the business each founder is expected to receive and in what form (profits, capital, assets, etc.) and if any vesting provisions apply, c) what happens in the event the business needs more capital, d) whether a partner can be removed for cause or without cause and how is that transacted (majority vote? unanimous vote?) FN1 and e) what happens when a person leaves the business (or dies) (i.e., how much does that person get and in what form (cash, equity, etc.).

These precautions can't prevent disputes. However, they can make any dispute considerably less problematic (monetarily and psychologically) for the on-going concerns of the business.

FN1
The removal issue in particular can be tricky. For example, it might seem strategic to include a provision in an operating agreement that prohibits any founder from being non-voluntarily removed from a management position since that would protect the founders from losing control of the company at some later date to subsequent investors. When you're starting a company it's natural to think that enemies will come from without not within. But business conflicts are a lot like the other conflicts in life. The bad guy is typically someone you already know.