Why the LLC is the Ruby on Rails of legal entities
Published February 13th, 2006 edit replace rm!
As my readers know by now I really like the LLC there are however one or two valid reasons to stick with a S or C Corp if you are a US based company. Brad Feld has added another good reasons for why S-Corps may be preferable to LLC’s:
While there are several advantages of an LLC over an S-Corp (ability to issue different classes of securities, ease of set up, informality of operating agreements, lower state taxes, non-US investors), venture funds typically cannot (or don’t want to) invest in LLCs. When a VC invests in an LLC, they risk getting an income tax called UBTI (unrelated business tax income). This type of income is frowned upon by investors in venture funds partnerships and most funds have a provision in their fund agreements that they will use best efforts not to bring UBTI into the partnership. As a result, VC funds shy away from investing in LLCs.
It’s good to see this particular reason
for it. So if you are planning to have investors in the future it would be a good idea for an S Corp.
He mentions the ease of conversion from a S-Corp to a C-Corp. Which is also a valid point.
LLC’s are like Ruby on Rails
However to put it in geek terminology then generally speeking the LLC is the Ruby on Rails of legal entities. It is fast and agile. It allows you to focus on your business now and not on the huge enterprise you will be in 2 years time.
Corporations are like J2EE
The corporation on the other hand was designed historically as an entity to protect outside investors. If you need outside investors from the get go thats fine. But if you are bootstrapping it is just like investing money in developing a huge J2EE application so you in the future can deploy it on a clustered Websphere server to keep your investors happy.
There are valid reasons to using J2EE, but many and most of them are based on outside pressures and not from your real business. If you look at the reasons for why LLC’s aren’t always a good idea you can see that virtually all of them are external compliance reasons. Such as Californias LLC Tax.
LLC is still the way to go in most cases
I still think that it is better in the short term to go for ease of implementation and this is exactly where the LLC counts. If you reach the point where you want investors, then go do the conversion from LLC to Inc and accept the cost at that point.
At early stages of a company the simplicity of an LLC keeps everyones focus on the business and not on future paper millions.
It’s the same thing as scaling your web service. Do you set up an expensive clustered environment while the only people who visit your site are yourselves, your mothers and a stray uncle somewhere. Is it really worth the time, effort and cost of setting up a super flexible “enterprise” when you’re not even sure you have a business yet?
As I have blogged about before there are some good reasons for when you should use C or S Corps, but unless you fit those reasons exactly I think it better to stick with LLC. One of these reasons it would appear is venture funding.
Oscar Toscano March 16th, 2007
I am still trying to find good operating agreement provisions for the LLC to bring on a few investor members. What are the most crucial points.
Lonnie Bledsoe June 15th, 2007
I have read lots and lots of material and still can’t decide what to do. If I am not looking for VC then should I go LLC? What about taxes? I have read that the SCorp offers more savings. Thanks for your help.
Pelle June 18th, 2007
Lonnie,
You of course always have to look at your individual situation.
I think the biggest tax difference between S-Corps and LLC’s are that LLC partners are liable for self employement tax instead of paying straight social security and medicare.
However active shareholders in S-Corps have to pay themselves salaries and social security. I’ve been told that the IRS will hit you if you take too large a proportion of your earnings as pass through income instead of salary.
However I’m not really sure of the limits. I’m in that situation myself right now, where I incorporated as a S-Corp for my personal holding/consulting company. Now have to do a lot of extra red tape to set myself up as an employee. I’m wishing I had gone the LLC route now just to cut all of that out.
I would be interested to hear from others about this.
Jeff Beard June 25th, 2007
I use a sole proprietorship (not yet an LLC since all current contracts offer indemnity) strictly to address my personal financial needs. This is the 1099 consulting that I do and will never have more than a few clients at a time or have any partnerships, investors, etc.
As you probably guessed, I also have a S-Corp which is for ventures above and beyond those that just pay the bills. Investors, partnerships, products, and more complicated projects that require staff augmentation are all done through the S-Corp.
I haven’t had the S-Corp in operation for long so the longer term value in the approach has yet to be realized but in the near term it is working as intended. I mitigate the complexity with professional services support (mostly my accountant).
Feedback on this approach is welcome.
Pelle June 25th, 2007
I think your approach makes a lot of sense. It’s really about keeping things simple.
Of course as I mentioned in Do S-Corps provide tax advantages over LLC’s S-Corp’s do come with a greater administrative overhead than LLC’s. But can in certain instances be better tax wise.
Good luck on your ventures.
Wanda September 12th, 2007
We currently have an S Corp and are trying to move a part of the business to a separate company. It sounded like a wholly owned subsidiary (LLC) would work, but my CPA does not seem to agree.
I’m questioning what the proper structure should be. There is a contract (vendor) attached that will have to have a name change.
I know I haven’t given a lot of info, but need the second company to be “linked” to the first.
Any thoughts?
Here is a thought January 17th, 2008
If by “ruby on rails” you mean an LLC seems easy to set up, but comes with hidden gotchas, is great for businesses that don’t make money, and won’t scale, then yep, I agree an LLC is the ruby on rails of legal entities.
These comments are hilarious. Make sure you spend just as much time building your business as you do twinking with its structure.
I think this blog post is the twitter of business-structure advice. And anyone seriously taking its advice without talking to an actual adult professional is the digger of entrepreneurs.
Pelle January 17th, 2008
99% of startups should focus on their product while they are in the early phase and not on advanced clustering advice or complex ownership structures.
I stand 100% behind that advise.
Professionals within any field though will always want you to put all your energy behind their particular expertise. This is as true for software development and server operations field as it is for legal professionals.
And while grey beards with Java logos on their T shirts and legal teams with suits can provide all kinds of scary reasons to listen to them. They are all irrelevant if you haven’t got a product.
So why don’t you provide some actual backing behind this and tell us about all the hidden gotchas.
UD June 10th, 2008
I am looking at starting angel investment fund and make that as LLC as we will have investors from outside US. This LLC can then invest in other S Corp within US. Though we are not talking about lot of money, if we do good job there would be good upside.
What would make sense for Angel fun? S Corp or LLC? We are expecting about 6-10 members.
Mark Hall May 3rd, 2009
IRS Form 2553 allows your LLC to be treated as a Sub-S for tax purposes. With this filing in place, you still need to pay yourself a reasonable salary, but at least part of your residiual income can be passed through without self-employment tax. It’s the benefits of a Sub-S without the hassle.
ariella November 9th, 2009
Mark- if you set up your LLC to pay taxes as an S Corp- do you have to pay payroll taxes etc throughout the year? and the formalities of an S Corp? or do you follow all of the rules of an LLC- except for the employment tax?
thanks