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The Practical Tech Lawyer: Should Your New Company Be a Limited Liability Company (an LLC) or a Corporation?
You’ve got a choice: LLC or corporation? (Yes, I know there are actually a few others, such as limited partnerships and business trusts, but those are used in limited circumstances for very sophisticated investors; for now let's focus on horses, not zebras.)
A corporation is a form of business entity that goes back more than two centuries in this country and remains the dominant form. (And if you choose a corporation, you usually have to make a choice between electing to be taxed as a “subchapter C” corporation, with taxation at the entity level, or a “subchapter S” corporation, with all taxable profits and losses passed through to the owners – see my posting, “Should your new corporation be a “C” corp or an “S” corp?”)
States began authorizing LLCs only a few decades ago, with the form achieving popularity only by the 1990s.
Here’s a nutshell comparison:
Liability protection: It’s a tie. Both forms limit the liability of the owners. Some people will tell you that the possible loss of this protection is greater with corporations, mainly because there are a few more formalities you can mess up, but I’ve never seen this as a serious risk.
Ease of corporate governance: The LLC is probably a little simpler to manage year-to-year. A little. Not much.
Tax reduction: It’s mostly a tie. A corporation that qualifies for and elects subchapter S corporation treatment passes through its profits and losses to its stockholders, as do most LLCs. (An LLC can elect to be treated like a C corporation as well.) But if the corporation doesn’t qualify for S corporation treatment, due to a large number stockholders, ownership by non-residents of the United States, multiple classes of voting stock, or other factors, then the LLC may be the only way to achieve pass-through taxation.
Flexibility. The LLC gives you a lot of flexibility to manage the company and allocate benefits the way you want. For example, you could have an LLC with 80-20 ownership that distributes profits 50-50 and losses 100-0. (This can make a tax headache, but the form allows it, subject to IRS regulations.) With a corporation, this kind of flexibility is missing.
Management. It’s pretty easy to hand over complete management power of an LLC to a single manager, and that’s the end of the problem. With a corporation, you generally have to deal with the election of a board of directors and the appointment of officers with defined responsibilities, requiring board approval of any activities that go beyond ordinary powers. This is where many people lose their taste for a corporation and go for an LLC, especially with family-owned businesses.
Fiduciary duties. In a corporation, the board of directors has certain fiduciary duties to the stockholders. For example, the duty of loyalty generally requires a director, among other things, not to learn about a business opportunity through board service and then try to use that opportunity for his or her own personal benefit, or the benefit of another unrelated company. This can be a bit of a problem for directors who sit on many boards, especially in related industries. With a Delaware LLC, these duties can be waived by the owners. They can also be renounced by Delaware corporations (see DGCL sec. 122(17)), which is often done by companies with VC investors so that their appointed board members can sit on several boards in related industries.
Ease of formation: It’s a tie, though many will tell you the LLC is preferred. You can form an LLC with a simple one or two-page filing at your local secretary of state and a filing fee of a couple hundred dollars, depending on the state. Technically, that’s all you need to do (in most states). Corporations begin with a similar filing and fee, but then you really need bylaws, minutes of an initial board meeting (try opening a bank account without that), stock certificates, a stock ledger and, if you really want to impress, a corporate seal and a corporate record book. In truth, those things are easy for any decent corporate attorney to create for you in about an hour. And even though the laws of most states do not require this (one big exception being Delaware, which does require an operating agreement), nobody should ever start an LLC without an operating agreement among the owners (even if there is initially only one owner). This operating agreement can be boilerplate-simple or quite complex. For example, you may want detailed rules on what happens if one of the owners dies, quits, gets divorced or gets fired. You might want special, non-proportional allocation of profits and losses. You may want non-standard rules about management of the company, or voting on important matters. All of this requires effort (lawyer time, I mean) to capture accurately in the LLC’s operating agreement. It’s the same for any special restrictions you may want on a corporation, which would be handled in an agreement among the stockholders. The more complexity you want, the more legal drafting you need and the less difference you will see between the ease of formation in one form compared with the other. The LLC has no significant advantage here, in my humble opinion.
So how do you sort through all these competing trade-offs?