Overview of Entities for Startups (C-Corp vs. S-Corp vs. LLC)
Separate and distinct from its shareholders (owners), C-corporations are standalone legal entities. Conceptually, courts view a corporation as a virtual person – being mindful, however, that transporting corporate documents in the passenger seat of a car does not qualify as a “person” for HOV lane use during rush-hour traffic, despite some creative attempts (see article).
In the business world, the distinction serves as a corporate shield to insulate shareholders against liabilities arising from the business’s financial and legal obligations (e.g. a person who buys Ford stock on the NYSE isn’t suddenly personally liable when Ford gets sued). Shareholders are then free to take risks for the business without fear of personal liability. But the protection is not absolute. Failure to observe rigid statutory formalities, such as keeping separate books and bank accounts, naming corporate officers to make everyday business decisions (the shareholders can, and often do, elect themselves as officers), properly noticing and conducting shareholder meetings, and issuing stock certificates, will result in piercing the corporate shield – subjecting shareholders to personal liability for corporate actions. Personal assets such as the owner’s real property, savings accounts, and other toys will be seized to pay for business liabilities.
What’s more, the structural rigidity extends beyond bookkeeping items. Shareholders must contribute equal dollar amounts for their proportional shares in the company, which makes sweat-equity arrangements difficult to execute. And once the contributions are made, corporations must divide earnings based on each owner's respective equity percentage (the number of shares he or she holds), which frustrates discretionary distributions of corporate profits.
Liabilities aside, one major drawback to the C-corporation structure is the imposition of “double taxation.” As a standalone entity, the C-corporation is taxed on any profits it earns (at the corporate tax rate). The shareholders are then taxed again when those profits are distributed to the shareholders (taxed as personal income). On the other hand, a major benefit to C-Corporations are not subject a self-employment tax.
Similar to C-Corporations, S-Corporations are distinct legal entities that must abide by the same corporate formalities. Unlike C-corporations, however, S-corporations enjoy “flow through” taxation. This means that shareholders only pay personal income tax on company profits; they do not pay any corporate-level tax. In effect, the S-Corporation avoids double taxation.
But with this flow through tax advantage comes additional restrictions, which arguably makes S-Corporations even more rigid than C-Corporations. Such restrictions include: having no more than 100 shareholders, of which may not include partnerships, corporations or non-resident aliens; and, having only one class of stock (making fund raising virtually impossible). There is another catch: although S-Corporations escape corporate-level tax, the shareholders must pay a self-employment tax.
Limited Liability Company
LLCs are also distinct from their “members” (LLC lingo for owner). And like the C and S corporate structure, LLC members are shielded from liabilities arising from the business. But unlike the C and S-Corporations, an LLC’s shield cannot be pierced for failure to observe corporate formalities – because there are no corporate formalities with an LLC. Rather, LLCs are formed through a contractual construct, as oppose to statutory edict, which allows members to run the business virtually any way they agree to under the operating agreement. For example, members can designate profit distributions however they would like, regardless of how much money a member puts into the business or how much ownership stake is conferred to any given member – this allows LLC members to contribute “sweat equity” for ownership. In addition, members may elect to manage the LLC by member vote, or by chosen representatives; members needn’t have annual corporate meetings and can design notice/meeting requirements as they see fit. Members can also sell their interest in the LLC to whomever they choose so long as they all agree in the operating agreement. In short, an LLC’s operational and structural design is limited only by the members’ imagination without constraints of bureaucratic red tape.
On the tax side, LLCs are “flow-through” entities with no entity-level taxation requirement (i.e. no double taxation). Members are taxed on their share of the business’s annual income and losses, which can be specified and divided in the operating agreement as the members’ desire. But like S-Corporations, LLCs are subject to self-employment tax, which is a major disadvantage compared to the C-Corporate structure.
The following table summarizes the differences between C-Corporation, S-Corporation and LLC operating and tax status.