Forming a Company
“I’m planning on starting a new business and have heard that I need to decide between forming a corporation or a limited liability company (LLC). What should I do?”
From the start, let’s frame your expectations about our response to this question, as there is not a “one-size-fits-all” answer about which entity type is the most appropriate for you. When working with our clients, our recommendations take into account several factors ranging from the company’s fundraising and growth plans to taxation strategies and the goals of the company and its founder(s). We are generally asked about three different types of entities: the LLC, the C-corporation and the S-corporation. In order to provide you with a bit more than an “it depends” answer, we’ve created a chart that includes some of the important factors to consider when forming a business and how these factors are treated in each entity type.
Note: each of the entity types requires payment of a filing fee with the state. The fees are usually comparable. The real difference in the cost of formation process relates to where you form your entity; see the discussion below.
Limited Liability Company
|Owners and Equity||Owners are called “shareholders” or “stockholders”; there are no restrictions on the number or type of stockholders; may have multiple classes of stock with different rights and preferences||Owners are called “shareholders” or “stockholders;” there are restrictions on S corps including (i) the owners must generally be U.S. citizens (natural persons); (ii) the entity may only have one class of stock with the same rights and preferences; and (iii) the entity may only have a certain number of owners||Owners are called “members;” equity interests are usually referred to as “units” or “membership interests;” operating agreement may provide for different classes of equity; no restriction on number or type of owners||The corporation “lingo” is more familiar to the general public. Some people may be confused if you call yourself a “member” of a company, but would understand if you used the term “stockholder.” As the prevalence of LLC’s increases, the LLC verbiage is becoming more mainstream. There is nothing wrong with referring to a member of a LLC as an “owner”, much like a stockholder is an owner of a corporation.|
|Liability of Owners||Stockholders are not typically liable for the debts and liabilities of the entity||Stockholders are not typically liable for the debts and liabilities of the entity||Members are not typically liable for the debts and liabilities of the entity||This factor, protection from personal liability, is an important benefit of forming a business entity and is one of the reasons that many small businesses take the steps to legally form an entity rather than operating as a sole proprietorship.|
|Management||The stockholders elect a Board of Directors. The Board of Directors appoints and oversees the officers of the corporation. The officers are responsible for the management of the day-to-day business of the corporation. Corporate by-laws establish certain rules regarding the management of a corporation.||The stockholders elect a Board of Directors. The Board of Directors appoints and oversees the officers of the corporation. The officers are responsible for the management of the day-to-day business of the corporation. Corporate by-laws establish certain rules regarding the management of a corporation.||The LLC may be managed by either the members or the managers, depending on whether the entity is “member-managed” or “manager-managed.” This designation is elected when the entity files its formation documentation with the state. An LLC may also have officers. An Operating Agreement provides important rules regarding the governance of an LLC.||Once again, the general public is probably more familiar with the corporation “lingo.” As such, LLC’s sometimes use the Operating Agreement to provide for more user-friendly positions and titles (ie. the creation of a Board of Directors of the LLC and the appointment of officers with familiar titles like CEO).|
|Taxes||No pass-through tax treatment; “double taxation”||Pass-through tax treatment under the S-corporation rules||The default choice is pass-through tax treatment under the partnership rules. However, the owners of an LLC can elect to be taxed as a S corporation or a C corporation if they choose. It is not uncommon for LLC owners to elect S corporation tax treatment.||Generally, in a C-corporation, the entity is taxed at a corporate level on its profits and the owners are taxed again on any dividends they receive (hence, “double taxation”). In contrast, “pass-through” tax treatment means that the entity itself doesn’t pay taxes and that the profits and losses of the entity are “passed-through” to the owners for tax purposes. Note that although both S corporations and tax partnerships are pass-through entities, the rules applicable to each are different in many material respects.|
|Investments and Funding||Due primarily to the lack of limitations on who may be a stockholder and the historical favoritism for C-corporations, this entity type remains the preferred entity type for many angel investors and most venture capital investors.||The restrictions on who may be an owner in an s-corporation exclude entity investors from owning a portion of the company. The S-corporation’s inability to have different classes of stock (like preferred stock) makes this entity type less attractive for investors.||The LLC does not have the same restrictions as the S-corporation as it can have entity owners and different classes of stock. While most institutional investors continue to favor the C-corporation, the LLC offers a very flexible platform for investment. The operating agreement serves as an imperative tool in setting up the rights of investors.||The C-corporation remains the preferred entity type for many investors as it’s a “tried and true” structure. However, a number of investors are attracted to the pass-through nature of partnership taxation and the incredible flexibility of the LLC format. In addition, it is often possible to convert from an LLC to a C corporation with minimal tax consequences if doing so is necessary to facilitate an investment. Similarly, an S corporation can elect to forfeit its S status by accepting investment from an entity or by issuing preferred stock.|
|Ongoing Maintenance||Corporations have certain statutory obligations related to annual board and stockholder meetings and must observe certain other “corporate formalities.” These requirements can make this entity choice less attractive for early stage companies and small businesses.
||Corporations have certain statutory obligations related to annual board and stockholder meetings and must observe certain other “corporate formalities.” These requirements can make this entity choice less attractive for early stage companies and small businesses.||LLC’s are more flexible than corporations in that the owners and managers are largely free to dictate the rules of the road regarding which procedures the entity will follow. LLC’s are not required to have annual meetings or to maintain certain formalities that are imposed on corporations.||The LLC definitely gets the nod on the “user-friendly” scale. While any entity type will have certain rules that the owners and managers/directors must follow, the LLC structure provides much more flexibility for those rules to be determined by the owners, rather than being imposed by statute, provided that they do so in a written operating agreement.|
|Other Notes||The C-corporation remains the “king of the castle” for companies that are seeking investment from major institutional investors. If your company is intending to seek significant investment at some point, the odds are that you’ll likely eventually end up as a C-corporation (via foregoing your S-election or converting your LLC), even if you’re a S-corporation or a LLC in the beginning.||Many small businesses elect to be taxed as an S-corporation at the beginning of their life cycle (remember, both corporations and LLCs are eligible to make an S election). For companies that don’t seek investment from outside parties, this entity type may be a good fit.||The ease-of-use and overall flexibility of this entity type make it a favorable choice for early stage companies and other companies that are not aggressively pursuing institutional investment. In the LLC world, having a well-drafted Operating Agreement is vital, as it sets forth the rules and structure of the entity.||We realize that this is a crash course in summarizing some of the factors that should be considered when thinking about which type of entity to form. There are a host of other factors that may be relevant as well. We’ll discuss some of the issues in further detail in other parts of the forum.|
Since we are a North Carolina-based law firm, many of our clients face the issue of whether to organize their new company in North Carolina or Delaware. Again, there is not a one-size-fits-all answer to this question. Delaware is well-known as having a business-friendly corporate legal system, and most out-of-state institutional investors are comfortable investing in a Delaware corporation. However, you will incur additional costs for local representatives and will pay filing fees and ongoing franchise taxes and administrative fees both in Delaware and in North Carolina (or wherever your principal place of business is located). If you aren’t seeking outside investment capital, it likely makes more sense to organize your entity in North Carolina and avoid the duplicate costs associated with having a Delaware entity.
“I’ve filed my paperwork with the state. Is there anything else that needs to be done to have a valid Delaware or North Carolina company?”
Filing the paperwork (Articles of Organization or Articles of Incorporation) is just the beginning step of the process of having a valid business entity. It is not enough! In order for your new entity to maximize the benefits of your entity, including insulation from personal liability, you need to:
- For corporations, prepare initial board of director and stockholder consents, to establish clearly the board of directors and officers, and for LLC’s, prepare and execute the Operating Agreement
- Prepare and execute other appropriate agreements between the founders and the new company (e.g., covering transfer of any needed intellectual property and tangible assets to the company)
- Obtain a Taxpayer ID number from the IRS and, if required, the State of North Carolina
- Obtain a business bank account, and scrupulously avoid commingling personal and business funds
- Make appropriate business privilege license filings and pay associated taxes in the city or county where your business is located