Continued: Should Your New Company Be a Limited Liability Company (an LLC) or a Corporation?

SOLOWAy | Schwartz

Technology Law Experts

Here’s how I do it:

First: Do you want pass-through taxation? Most people like the idea of avoiding taxes at the entity level. But some prefer to take entity-level taxation (especially if losses are expected for a while) as the cost of avoiding the administrative headache of pass-through profits and losses.

Next question: If you want pass-through taxation, then does your company qualify for S corporation status? (See www.irs.gov/pub/irs-pdf/i2553.pdf.) If no, you can only achieve pass-through taxation using the LLC format. (Again, we’re ignoring limited partnerships for now.)

But here’s another question that might push you the other way: Will your company give equity compensation to employees, in the form of restricted shares or options? If the answer is yes, you probably want a corporation. The accounting and tax issues for equity compensation of LLCs are tricky due to the byzantine complexity of partnership accounting (assuming the LLC, like most, does not elect to be taxed as a corporation); these tax and accounting rules are relatively simple for corporations. Ask your accountant for an opinion on this, but I nudge people toward corporations when they plan to award employee equity.

Do you expect to take on professional investors in the foreseeable future? Most VC firms will not invest in LLCs. (The pass-through profits and losses are too difficult for them to deal with.) A few angel investors – individuals with less reason to shun pass-through profits and losses – may put money in LLCs, but many won’t. That’s just how it’s done in 2012; in a few years maybe that will change, because there are ways around all of these issues. You can start with an LLC now and convert to a corporation when the time comes for your first major investment (there can be tax implications in this conversion, too), but you might prefer just to start now as a corporation. And if your new business is the kind that VCs and angels might want to support, it’s also very likely that your employees and advisors will be receiving restricted stock or options, which makes the choice of a corporation fairly easy.

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If you’re not expecting employee equity awards or VC investors, you may be happier with an LLC. Family-owned businesses usually go this way because of the LLC’s perceived simplicity of operation. Complex investment vehicles, like real estate holding companies, often go this way due to the LLC’s flexibility in structuring simple management with complex ownership rights.

This is not the most complicated material you’ll ever deal with, but it’s tricky and subtle enough to justify speaking to both a lawyer and an accountant before you begin.

© 2012 by Robert G. Schwartz, Jr. All rights reserved Disclaimer: This summary is provided for educational and informational purposes only and is not legal advice. Any specific questions about these topics should be directed to an attorney.