What an LLC is
A limited liability company gives its owners, called members, the same basic protection a corporation gives stockholders: the business's debts belong to the business. Beyond that it is built for flexibility. Instead of a statute that prescribes boards, officers and stock, an LLC runs under an operating agreement its members write, and they can divide profits, votes and control however they like.
The bigger difference is tax. By default an LLC with more than one member is taxed as a partnership. It pays no income tax itself; its profits and losses pass through to the members, who report their shares on their own returns whether or not any cash was distributed. An LLC can elect to be taxed as a corporation instead.
When an LLC is the better choice
For many businesses an LLC is the right answer. A consulting firm, agency, online store or local business that pays its owners out of profits avoids the corporate double tax. A business that will lose money early, owned by people who can use those losses against other income, gets the benefit of pass-through treatment. Real estate and investment vehicles are usually LLCs or partnerships. And a business owned by a few people who never intend to raise venture money or grant stock options widely gains little from being a corporation.
Why venture-backed startups avoid them
The first reason is the venture funds themselves. A venture fund is usually a partnership whose investors include university endowments, foundations, pension funds and foreign investors. When a fund owns part of an operating LLC taxed as a partnership, the LLC's business income flows through the fund to those investors. For tax-exempt investors it can be unrelated business taxable income, and for foreign investors it can be income connected with a U.S. business, which forces them to file U.S. tax returns. Fund agreements often prohibit investments that cause those problems, so funds invest in corporations.
The second is paperwork. Every member of an LLC taxed as a partnership receives a Schedule K-1 each year and has to wait for it before filing their own return. That is manageable with three owners and a burden with fifty employees holding equity.
The third is equity compensation. Corporations grant stock options under rules that employees, recruiters and payroll providers all know. LLCs grant profits interests, which can work well but are harder to value and harder to explain.
The fourth is the qualified small business stock exclusion, which applies only to stock in C corporations. Gains on LLC interests do not qualify. If you convert an LLC to a corporation later, the holding period starts at conversion and only value created after conversion can qualify.
Finally, converting later costs time and money. Delaware lets an LLC convert into a corporation with a single filing, but a conversion still needs tax advice, a valuation and new documents, usually in the middle of a financing. Most startups that know they want venture money skip the detour.
S corporations
An S corporation is not a separate kind of entity. It is a corporation, or an LLC, that has elected to be taxed as a pass-through under Subchapter S. It may have only one class of stock and no more than 100 stockholders, who generally must be U.S. citizens or residents and individuals rather than funds or companies. A venture fund cannot own S corporation stock, and the first preferred stock financing would end the election. Startups that plan to raise venture money stay C corporations.
If you expect to raise from angels or venture funds, give equity widely and eventually sell or go public, form a Delaware C corporation. If you expect to distribute profits to a small group of owners, talk to an accountant about an LLC.