Look at the end game when deciding whether to structure your startup as a corporation or LLC. You’re probably starting a business to make money. How will you get your money out of the corporation or LLC? If you take on investors, how will they get their money out of the corporation or LLC? These answers will lead you to the right structure.
“Raise Capital, Grow the Business, Then Sell it.” Corporation or LLC?
In this case, you want to structure your business as a corporation.
For many startups, the end game is to grow the business and sell it: that is how the founders will make money. Along the way, in order to grow the business, you will need to take in outside investment, and the investors’ expectation is that they will make their money when you sell the business. You may also need to use equity compensation (stock options) to attract and retain the best talent because the company will not have sufficient cash or profits to pay market salaries.
When this is the case, the optimal structure is a corporation. Investors prefer investing in corporations because it can offer significant tax advantages over LLCs. Investors also prefer investing in corporations because their legal rights and obligations, such as the duties of members of the board of directors and the legal documentation, are more standardized. From the employee growth perspective, the corporation-or-LLC question favors the corporation as well because awarding employees stock options is fairly easy and doesn’t require amending the company’s formative documents every time the company wants to add a new equity owner.
As for the “double tax” pitfall of structuring your business as a corporation, it doesn’t come into play if the goal is to create a high-growth company and grow it big. To the extent there are profits in the business, the profits will be reinvested in the business, not distributed to the stockholders, so the “double tax” should not be an issue.
“Generate Profits and Cash Flow the Business.” Corporation or LLC?
In this case, you want to structure your business as an LLC.
For other kinds of businesses, the end game is to make profits and distribute them to the owners; in other words, to cash flow the business. When this is the case, the corporation-or-LLC formation question favors the LLC because it has pass-through taxation. In other words, the LLC is not taxed on its profits. The owners of the LLC are taxed on the profits, but when the LLC distributes the profits to the owners, the distribution is tax free. With only one layer of federal income taxes, when the goal is to distribute cash to the owners, the after-tax returns will be higher with LLCs.
Image credit: CC by Vic
