I was quite proud of my first foray into the blogosphere.  In fact, I had great ambitions to write a whole series of legal related posts for the entreprenuer.  However, the only two comments (the verbal kind) I received on my first post essentially were that it is the most boring thing they have ever read (and one of people saying this is a tax lawyer!).

Accordingly, I am revising my plan (though not giving up on addressing legal issues for the entrepreneur).  The posts hopefully will be less “bookish,” more practical and marginally more interesting.

With that in mind: Entity Formation

There are certain types of businesses that will form as partnerships, S-corporations, etc., but odds are, your decision of the type of entity you want to create likely will be a binary one between an LLC and a traditional “C” corporation.

While LLCs and corporations have many similarities (e.g., limited liability), they also have a number of differences.  The principal one of these is the tax treatment.  Corporations pay their own taxes.  LLCs do not.  Income and losses of an LLC flow through to the owners of the LLC, who pay any taxes directly.  This means that to the extent a corporation makes a dividend of taxable income, that income will be taxed twice (once at the corporate level and once at the shareholder level).  This can be a very significant benefit.  People often focus on this “double taxation” issue and assume LLCs are the superior business vehicle.  All else equal, that is true.  However, not all else is equal.

A number of factors tend to favor corporations over LLCs.  For example:

• due to the flow through nature of LLCs, the admnistrative burden of keeping track of capital accounts, allocations, distributions, etc., in LLCs can be quite high.  This is largely non-existant with corporations.  Quite possibly, the tax savings associated with LLCs may be outweighed by administrative costs.
• the “double tax” only is an issue to the extent (1) a corporation has taxable income AND (2) the corporation issues a dividend.  Most early stage companies are not going to fall in that category.
• VCs rarely invest in LLCs (primarily because they don’t want pass-through income).  If you are going to raise VC money, you need to be a corporation.
• Because LLCs are highly driven by tax issues, legal fees tend to be higher with certain types of LLCs.
• Operating agreements can be very complicated (and costly) documents to create.  By comparison, bylaws (the corporate functional equivalent) generally are very straightforward and inexpensive to create.
• The more an LLC wants to “look like” a corporation (i.e., equity incentive plan, different classes and series of membership interests, etc.), the more expensive they become.  Corporate stock option plans, separate classes and series of stock, etc., while not necessarily “cheap” to create, generally are must less expensive by comparison.
• Although LLCs apparently date back to 1892, they are a relatively new creation in the United States.  The body of law surrounding corporations is better understood, better settled and more predictable than LLC law.

While LLCs have many beneficial characteristics, one should not focus on potential tax benefits to the exclusion of other relavent factors.  While there may be an argument that some corporations would be better off structured as LLCs, there is good reason corporations outnumber LLCs.