Sometimes people get too enthralled with LLCs. Sometimes the flexibility seems really exciting and appealing.
To give you an example of the flexibility:
Did you know, for example, that you can form an LLC and make an S election? That's a great thing isn't it? Isn't that easier than forming a corporation under state law and going through the hassle of additional corporate documentation?
Simplicity Can Turn Out a To Be More Complex
There is a belief, especially amongst CPAs it seems, that state law corporations are substantially more difficult from a paperwork perspective than LLCs. This is generally not true. In fact, except for single member LLCs, corporate documents are easier to put together than LLC documents.
Here is the trouble: you form an LLC because you want to keep things simple. If you are going to be the sole owner for as long as you can imagine, you have probably made the right call. Single member LLCs are easier than one shareholder corporations.
But if you want to grant stock options to employees, or if you think you might want to seek angel capital a few months from now, don't start out as a state law LLC.
First, a few things about LLCs
LLCs are state law entities. But for federal income tax purposes they can be any number of things:
- They can be a "disregarded entity," meaning they are considered to be a sole proprietorship if owned by one individual, or a division of a corporation if wholly owned by that corporation.
- They can be a partnership of owned by several people.
- They can be a C corporation, if the LLC checked the box to be taxed as a corporation.
- They can be an S corporation, if they checked the box to be taxed as a C corporation and elected to be an S corporation.
You might like all this flexibility. True, in some cases it is nice. But if you are an early stage company that wants to raise angel or venture capital, grant stock options, and follow the traditional growth company route, just say no to LLCs.
When Are LLCs A Good Idea?
LLCs are a good idea in the following situations:
- You will have a set group of owners from the start, and you don't plan to regularly grant the equivalent of stock options to new hires or raise angel or venture capital.
- You are forming the entity to build a business that will be a cash cow for its owners.
- You are forming the entity to invest in real estate or venture capital style investments.
- It will be wholly owned by you.
State Law Corporations Are Great
Forming a state law corporation is not that much more difficult than forming an LLC. And the benefits of starting in the corporate form, even if you want to be an S corp initially, are substantial. They are:
- You can easily convert an S corp to a C corp before or incident to an angel financing. Converting an LLC to a corporation before or incident to an angel financing typically requires more work.
- State law corporations that are taxed as S corps can grant stock options. It is very difficult to grant the equivalent of stock options in LLCs, especially LLCs that have checked the box to be taxed as S or C corporations.
But perhaps the biggest reason I am not a fan of forming an LLC and then checking the box to be an S or a C corporation is the unfamiliarity of that form of doing business. especially if you potentially want to raise angel capital. Doing business through a form that is unique or unusual means spending more time and money on legal matters, not less. Typically entrepreneurs want to minimize legal expense. And certainly investors do not want to confront an unusual legal structure that is difficult or hard to understand.
Follow The Typical Path
My advice: follow the typical path, if you want to grant stock options and potentially raise angel or venture capital. Don't do business through a unique or unusual legal structure. It is more pain than it is worth.