VC Deal Lawyer

Here’s some quick information on the difference between S-Corps, C-Corps and LLCs.  This is meant to be a summary rather than gospel; entire chapters have been written on this topic elsewhere. 

The first thing you should know is that people run their business through a corporation or limited liability company because they desire to limit their liability to third parties.  How does that work?  If corporate formalities (e.g., having Board and shareholders meetings, electing officers, hiring accountants and bankers) are followed by the shareholders, then only the capital invested by the shareholder is at risk.  Someone would have to pierce the corporate veil (generally a difficult task) in order to hold a shareholder liable for more than their invested capital.  By providing limited liability, states encourage individuals to take the risks associated with growing a company.

Corporations

Corporations have traditionally been the vehicle used by for-profit entities.  There are two general types of corporations, with one of the primary differences being how they are taxed.  Regardless of which type of corporation you choose, operating through a corporate entity provides shareholders with limited liability. 

The first type is a C-corp.  A C-corp has two levels of taxation.  First, corporate income is taxed separately at the entity level.  Later, if any distributions are made to the shareholders, then those distributions are also taxable to the shareholder personally.  C-corps have no restrictions in the number of shareholders or in the types of stock that it can issue.

The second type is an S-corp.  S-corps have some limitations that C-corps don’t have.  To qualify as an S-corp, the entity cannot:

• have more than 100 shareholders;
• have shareholders other than individual U.S. citizens or permanent residents (with some limited exceptions);
• cannot have more than 25% of its income generated from passive activities (think landlord); and
• can only issue one class of stock (except that you can have both voting and non-voting common stock).

In return for qualifying as an S-corp, the entity gets the benefit of having a flow-through-tax status meaning that the entity itself does not pay a separate tax.  “Flow-through” meaning the tax flows through the entity straight to the shareholders.  In effect, it eliminates the tax on corporate income at the entity level that you have with a C-corp.  All of the taxes of an S-corp are paid by the shareholders themselves through their own individual tax returns.  Once an entity no longer qualifies as an S-corp, it converts to a C-corp.

Putting aside the tax issues and the qualifiers for being an S-corp, no real differences exist between S-corps and C-corps.

Limited Liability Company

A limited liability company is a hybrid model that provides a bit more flexibility over an S-corp or C-corp.  In fact, it provides limited liability just like the corporation, but it allows for both individuals and entities to be members (LLC vernacular for shareholder) without altering its flow-through-tax status.  That’s why LLCs are popular in some crowds, because they blend the favorable aspects of S-corps and C-corps.  LLCs are generally governed by a Limited Liability Company Operating Agreement.  Anyone can be a member, there is no tax on corporate income at the company level and members can agree to divide profits in ratios that aren’t synonymous with their ownership ratios.  The last point cannot be done in an S-corp or C-corp.

That being said, I view limited liability companies as being more appropriate for lifestyle companies, mom-and-pop type operations and professional service organizations.  Most venture backed companies tend to be corporations.  In addition, sole proprietorships, general partnerships and limited liabiliy partnerships are not structures that you typically see utilized in venture backed companies, for reasons too detailed to express in this forum. 

As always, consult your accountant when picking the proper entity.