LLC v. Partnership v. C Corporation v. S Corporation

1. Guide to Legal Entities for Start-Ups
Partnership, LLC, S Corp, orC Corp?
I. Partnerships
Most businessesstartassole proprietorshipsorpartnerships. Partnershipsare eithergeneral orlimited
or general fora specificpurpose.Anylimitedpartnershipmayinvolve securitiesissues.The main
advantage of the partnershipentityisthatitcan formedwitha letteragreement. Itactuallycanbe
formedwithevenlessthan that,butitis bestto putbusiness undertakings inwriting.
Most partnership soon evolve intoLLCstotake advantage of limitedliability. Twoof the mostcommon
early legal businessstructuresare the limitedliabilitycorporation(LLC) andthe S Corporation.There is
alsothe C Corporation.AnLLC offersadvantagesoverall of them atthe outset.
II. LLCs
An LLC allowsabusinesstosetup an ownershipstructure thatmakessense forliability andtax
purposes.Unlike anS Corp inwhichthe share structure mirrors the amountinvestedbyeach
shareholder,anLLChas flexibility.Thisisimportantasprofitsflow throughanLLC and hence are taxed
to the owners.Profitdistributiondoesnot have tomirrorpercentage investmentinthe company.
1) Transfer of Ownership
In an S Corp,sharescan be sold,giftedorwilledtoothers,creatingchanges inownershipstructure and
possible leadershipanddirectionissues.InanLLC, if itis dissolved,say uponthe bankruptcyordeathof
an owner,or due to business disagreements, some ownerscan regroupand simply setupa new LLC.
2) Less Paperwork
All corporations,includingS andC Corps,are requiredtoholdregularshareholdermeetingsand
memorializethe matterscoveredinsuchmeetings.A boardof directorsmakes decisionsbymeansof
formal documentedresolutions.AnLLChasno needforminutes,resolutionsor meetings.Thisreduces
time spentonadministrationpaperwork asopposedtostrategicplanningandexecutionof the business
plan.
3) Lower State FilingTaxes
AlthoughLLCspay no federal income tax,state filingtaxesare paid.The annual state filingtax is lessfor
LLCs than itis for S Corps.In some states,LLCswithonly one or twomembersdonot evenpayan annual
state filingtax.The annual filingtax isalwayslowerthan forS Corps.

2. 4) Simple to Set Up
Formingan LLC is easy.The feesforsettingitup are generallylow.Yougain limitedliability andyouget
pass-throughtax treatmentwithoutthe "double taxation"of aC Corp.
Many businessesstartoutasLLCs andthen change toa C or S corporations. Keepreading.
III. S Corporation
The S Corporationisa popularstructure forsmall businesses inpartbecause the companyistaxedlike a
sole proprietororpartnership.The companyitself doesnotfile itsowntaxes; all companyprofitsand
lossesare "passedthrough"andreportedaspersonal income of the shareholders,justas, inthe case of
an LLC, to the members.
1) Business Formality
S Corporationsinvolvecompliance obligations whichcanbe initially burdensome forafounder.If you
incorporate asan S Corporation,youneedtosetup a boardof directors,file annual reports, make other
businessfilings,holdshareholder’smeetings,keeprecordsof yourmeetings,and operate ata higher
level of regulatorycompliance. LLCsuse an informal operatingagreement.If youwantlessredtape and
formality,the LLCis foryou,at leastin the first days.
2) Who Can Be a Shareholder?
The S Corp cannot have more than 100 shareholders.Obviously,thisisnotrelevanttomoststart-ups.
All individual shareholdersof anSCorp mustbe U.S. citizensorpermanentresidents.Also,if youwant
an LLC to be a shareholderyoucannotforman S Corporation andyou probablyshouldoptforan LLC
until youare readyto be a C Corporation.
3) Income Allocation
Withan LLC, income andlosscan be allocateddisproportionatelyamongthe ownerswhereasinanS
Corp income andlossare assignedtoeach shareholderbasedontheirpro-ratasharesof ownership. This
can be important.SaySteve andMike openan autodealership asco-owners. Mike soonneedstofocus
on otherthingsand Steve doesmore andmore of the work. Theydecide Steve should take 65% of the
profits. Withan LLC, everythingisgood;the partnersare taxedpursuantto the termsof theirLLC
OperatingAgreement. ButnotwithanS Corporation.Since Steve andMike are 50% owners,eachwill be
allocated50% of the corporation’sincome.
4) Pass-Through Losses

3. WithLLCs andS Corporations,membersandshareholders applycompanylossestotheirpersonal
incomes.Inan LLC, forinstance, memberscan addthe amountof the mortgage to theirbasisfor the
purpose of computinga loss.
5) Class of Stock
In an S Corporation,all shareholdersownone classof stock.AnS Corporationcanhave votingand non-
votingsharesbut cannot have commonstock andpreferredstock. (See discussionbelowregardingC
Corps). Inan LLC, prioritiesandpreferencesare allowed,andyoucanhave differentmembership
classes.Youcannot offercommonandpreferredstockclassesinanS Corporation.
6) ReinvestingProfits
As pass-throughentities,individualownersof anS Corporationor an LLC are liable forall taxesowedon
profits— whetherthatmoneyisretainedinthe companyorput intheirwallets.Forexample,if Mike
owns10% of an S Corporationandthat companymakes$1,000,000 in profit,Mike needstoreport
$100,000 inincome on histax return.Thisis the case whetherornot$100,000 was put inhisbank
account. Thisisknownas “phantomincome.”If youplanon keepingmoneyinthe companyandwould
prefernotto have be personallytaxedonthismoneyasa shareholder,youshouldconsiderthe C
Corporationoverboththe LLC andS Corp.
7) Private PlacementFunding
If your companyis consideringraisingprivate equityorventure capital down the road,institutional
alternative fundingsourceswill likelydemandaC Corporation.Yourbusinessdoesnotneedtostartas a
C Corp, butif you are consideringraising seriousprivate capital youwill needtoconvertthe businessto
a C Corp at some point.
Thisconversionwill require additional filingsandfeeswithinyourstate.Thisiswhysome entrepreneurs
considerthe S Corpthe default option,since convertinganSCorp to a C Corp can be done ina day with
a single tax form.
IV. C Corporation
1) LLC vs. C-CorporationTaxation
The most obviousproblemwithCCorporationsisthattheydonotofferthe pass-throughadvantages
that LLCs and S Corporationsdo.The corporationwill paytax on anyprofitsandemployeespaytaxeson
salaries,andif there are any profitdistributionsbymeansof dividendsowners will be taxed(again).The
tax code is not friendlytoaC-Corporationthatwantsto provide profitstoshareholders.If those
shareholdersare alsoemployees,therewillthree differentpointsof taxation!

4. LLCs looklike theyhave onlyone pointof taxationbutinrealitythere isasecondpoint.There isself-
employmenttax and income tax.Payingself-employmenttaxesisstill betterthanpaying CCorp taxes
because the C Corp needstopay an employmenttax on salaries(the same asa self-employmenttax).
2) Hold profitsin or not
Withthe C Corpyou can holdprofitsinthe corporationratherthan pay themout.If you are profitable,
youwill wantto holdprofitsinandpay yourself aminimal salary.If youexpecttoexperience losses,asis
usuallythe case inearlystage companies,the LLChas advantages inthat LLC losescan offsetother
income.A C Corp will carrythose losses(forcreditagainstfuture profits) butthe owner,asa tax-paying
employee,doesnot gettomake use of them.He or she will have additionalW-2income.
3) Ownershipstructure of LLCs
The systemicdrawbackto LLCs isthe problemof how youdeal withthe ownershipstructure.
LLCs do not have shareholdersandsharesof stock; insteadtheyhave "members"and"units.” InanLLC
each memberisthe same as e very othermembers.Everyone isworkingunderthe same operating
agreement: investors,the founderorfounders, any employeeswhohave beengiven (orexpectstobe
given) ownership –all are the same;there isnodifference betweenthem.
4) Ownershipstructure of C Corps and Flexibility
C Corporationscanissue differentclassesof stock.A founder mighthave preferredstockwhile
employeesandinvestorshave commonstock.Those classescanbe subdivided. Firstinvestorscanget
"SeriesA PreferredStock"withcertainrightswhile laterinvestorsare given "SeriesBPreferredStock"
withdifferentrights.CCorps alsoallowforordinarystockoptionsforemployees—ownershipin
exchange fortheirloyaltytothe company--while the ownersholdonto“foundersstock.”Also,select
vendorscan be given stockwarrantsin exchange forprovidingdiscountedservices.
5) C Corp stock options
If you ask an investortoputin moneyat$100 per unitand then yougive him1,000 units,youhave
subjectedthatemployee toatax hit.The IRS will saythatyou “paid”the employee $100,000 and he
owesincome tax at ordinaryincome rates.Soyouremployee isout,say, perhaps $30,000 in taxes.
But witha C Corp, youcan create a stockoptionplanto give to-be-vestedownershiptoemployees.The
optionprice mustbe equal to the fairmarketvalue of the underlyingclassof stock at the time the
optionwasgranted. The companywill grow (we are assuming) so bythe time the stockvestsitwill be
worthmore than whenitwas granted.The employeewillhave topaytax onthe gainwhenhe exercises
those options, asshortterm capital gain, notordinaryincome.

5. In a C Corporationall classesof stockare usuallynotcreatedequal and,therefore,are notpricedthe
same.The preferredsharescanhave benefitsthatmake themmuchmore valuable.
So whatto do?
Private PlacementAdvisorsstartsnewclients withanLLC.Aftersuccessandthe founder(s)want to
grant stock optionstonew(orold) employees,oroutside investors,we converttoan S or C Corporation.
Whenyouare talkingto majorinvestorsand/ordealingwithemployee optionpools,C Corporationsare
usuallybest.Whenitis youand one or two partners, use anLLC. But be careful withthatLLC. You do not
wantto endup witha large number of investorswhohave investedatdifferenttimes -- withno
flexibilityinhowthose shares/unitsare pricedorstructured.
Private PlacementAdvisorsLLCisa groupof expertswho draftandfile disclosureandoffering
documentsforreviewbyregulators andinvestors.
We are JOBS Act expertswhocurate crowdfundingandpeer-to-peerplatforms,writeclients’pitch
decks,write andfile clients’offeringdocuments,andassistclientsininvestorpresentations.
Managing partnerDouglasSlain,aStanfordLaw graduate withbigfirmexperience,authoredthe 10-
volume PrivatePlacementHandbookSeries.