If your business is based in California, it is privately-held, and you are owned by a few shareholders, you might be best served to incorporate in California and pay annual fees and taxes in one state.
Because a company that does business in California must pay California taxes, a company incorporated in Delaware will still subject that company to California taxes. And, as a Delaware company it will also have to pay Delaware franchise taxes. However, if the company is interested in seeking venture capital or private equity financing, has a large number of owners, or one day wishes to hold an initial public offering, Delaware might be right for you.
This is because, for the most part, Delaware is far more preferable to California – and other states – for a host of reasons benefiting a growth company. Why? It is more management favorable, offers stronger protection for board members against derivative suits (lawsuits initiated by shareholders on behalf of the corporation), and is less favorable to minority shareholders as in other states. In addition, Delaware is more protective of companies through statutory protections from actions such as hostile takeovers. For corporations seeking venture capital with plans to go public, Delaware is likely a better place to incorporate. For other companies conducting business in California, such as close corporations and small business owners not likely to go public, California is likely the preferable choice to form the company.
LLC vs Corporation?
The first distinction is between what the legal entity is and what the taxation treatment is for the respective entity. A corporation, either C-corp or S-corp, will be taxed as a corporate entity. A limited liability company (also known as an LLC) can decide how it wants to be taxed. An LLC can be taxed as a partnership, as a C-corp, or as an S-corp. It can also elect to be “disregarded” for tax purposes.
An LLC has greater flexibility and can choose the tax identity that most benefits its owner or owners (called members). A corporation may be subject to the implications of double taxation. A C-corporation's profit is taxed once at the corporate level, and again on an individual shareholder level when corporate dividends are received. The S-corporation designation allows for “pass through” taxation to the shareholder level (i.e., no tax at the corporate level), but there are certain requirements to qualify as an S-corp that may limit allowance.
An LLC, on the other hand, no matter its structure or organization, can choose how it wants to be taxed. By default, an LLC is treated as a "pass-through" entity (single taxation), but can easily elect to be taxed as a C-corp or an S-corp.
C-corps allow for an unlimited number of shareholders, there is no limitation on who can hold shares, and no restrictions on what types of shares can be held (such as preferred vs. common). A C-corp is perfect for a company looking to go public. S-corps are a bit more restricting. All shareholders of an S- corp must have U.S. citizens or permanent residents as shareholders, and there can only be 100 or less of them, and for most part, there is only one class of stock. An LLC does not issue shares, but it can have multiple owners who all share a percentage of the company, called membership interests.
The best decision for choosing the type of entity takes into account many factors.
The simplest rule of thumb:
C-corps are great for businesses that sell products, have employees, or offer services where the taxes are high.
S-corps are a good choice for businesses that have significant start-up costs because of their flow-through taxation so long as they qualify for this structure.
LLCs are great for businesses whose owners who seek flexibility, or want an entity to hold real estate or other appreciating assets that limits their liability. They are a popular choice for investors and entrepreneurs because of the flexible taxation and great asset protection.
So who wins? As my grandfather once said, “It depends.”
Michael C. Carroll, Esq., Managing Partner, CorpGen Counsel brings a wealth of securities, governance, M&A, private equity, real estate, transactional, and general corporate law experience to public companies, privately-held companies, private equity firms, and individual clients. Mr. Carroll was previously Senior Vice President, Chief Compliance Officer, and General Counsel of Medallion Financial Corp., a NASDAQ-traded commercial lender and FDIC-insured bank, and was Senior Counsel of Aames Investment Corporation, a NYSE-traded real estate investment trust. Prior to his in-house positions, he practiced in the corporate law department of the international Am Law 50 law firm of Willkie Farr Gallagher, LLP in New York.