To a large extent, but not exclusively, whether to be a “C” corporation or an “S” corporation or a limited liability company (and “LLC”) is a tax issue. LLCs and “S” corporations are so-called pass-through entities. That is to say that the entity itself is not taxable; its tax attributes (profits and losses) are passed through to the owners of the entity, and they pay tax in accordance with their particular tax situation (often at the highest marginal rate for individuals – assuming they are well-to-do). (Most LLCs and “S” corporations distribute cash to enable their owners to pay these owner-level taxes.)   Distributions or dividends that an LLC or “S” corporation pays to its owners are then free of a second level of tax.  Profits of a “C” corporation, on the other hand, are subject to double tax: first, the entity itself is taxed, and the shareholders are taxed on any dividends paid to them.

Sometimes entrepreneurs like LLCs or “S” corporations because they believe they can use start-up losses to offset income from other sources and can then enjoy a single level of taxation once the business is profitable.

In some cases there is not much choice. If you plan on venture financing, you are more or less required to be a “C” corporation. The reasons for this are first, tax law does not permit venture funds to invest in “S” corporations, and secondly,  most venture funds will resist investing in an operating company that is an LLC. This is because most venture funds have investors that are themselves tax-exempt entities, such as pension funds and endowments. The income from an LLC would pass through the LLC and the venture fund to these tax-exempt entities as taxable income. This becomes a nightmare for them, so they just won’t make those investments. 

If you do not plan on professional financing, however, you may have some choices.If you are contemplating an LLC or an “S” corporation, here are some things to think about:

If you think you may need venture financing in the future, you can form an LLC or “S” corporation and later convert to a “C” corporation, generally tax-free, in connection with the financing.

LLCs cannot grant incentive stock options (although they can grant tax-free “profits interests,” but these are more complicated, and employees are less familiar with them)

LLCs cannot engage in tax free mergers

LLCs can be more complex, and therefore more expensive to form than corporations (either “C” or “S”).

The accounting for LLCs can be  more expensive than for corporations (either “C” or “S”)

Tax treatment of LLCs and “S” corporations vary from state to state, leading to expenses and headaches.

“S” corporations are not allowed to have more than one class of equity.

“S” corporations cannot have stockholders that are not U.S. persons.

“S” corporations cannot have stockholders that are not people (except for certain estates and trusts).

“S” corporations may not have more than 100 stockholders.

Inadvertent violation of “S” corporation requirements can have negative tax consequences for all the “S” corporation stockholders.

Losses being passed through are often passive losses and may not be deductible by most passive investors.

Unused losses may be lost when an LLC becomes a regular “C” corporation.