One of the common questions I am asked by startup founders is what type of entity should they form. They often receive conflicting advice from CPAs and startup advisors. There are multiple choices but one clear winner: the C corporation.
When most founders launch a startup, one of the last things they want to think about is choice of entity. They want simplicity, low cost, and the least amount of distraction from the thousands of other things that they need to do to get their startup off the ground, but setting up an entity is necessary if founders ever want to attract investment and limit personal liability. When it comes to setting up an entity, there is one major decision that can set the tone, not only for founders and employees but also those who will invest in the company: the type of entity you form.
The most common advantage you will hear from people who recommend forming an LLC is that you can avoid the “double tax” associated with a C corporation. What people are referring to with "double tax" is that the profits of a C corporation are taxed first at the corporation level (it pays the first tax), and second, if those profits are distributed to the corporation’s shareholders in the form of dividends, then the shareholders will have to pay tax on those dividends.
This is true. However, most startups are not profitable and those that are drive all of their profits back into the growth of the company. As such, startups are hardly ever subject to the double tax.
Why Shouldn’t a Founder Choose to Form an LLC?
For tech or growth companies planning to follow the traditional path of regular and ongoing equity grants to employees, multiple rounds of financing, and reinvestment of as much capital into the business as possible, with the goal of an ultimate sale to a big, maybe public, company in exchange for cash and/or stock, LLCs are typically not the way to go. Below are a few of those reasons.
1. Equity Compensation Is Complicated in an LLC
One of the most attractive incentives for startups to offer employees, advisors, and other service providers is equity compensation in the form of restricted stock and stock options. People seem to have a general understanding of how these work. In contrast, providing equity compensation in entities taxed as partnerships is much more difficult, complex and expensive to draft and administer than equity compensation in a C corporation.
The equivalent of a stock grant in an LLC is a “profits interest” which, when issued, often makes the LLC “book up” the capital accounts of the owners prior to granting the profits interests. This same complication occurs with options or warrants to acquire LLC interests. Additionally, if a W-2 employee receives a profits interest, then she will be treated as a partner for tax purposes and can no longer be treated as a W-2 employee.
2. LLCs are Not Eligible for Section 1202 Gain Exclusion
Section 1202 is one of the most exciting tax incentives for founders and investors alike. This section of the tax code allows founders and investors to exclude up to $10 million in capital gains from the sale of qualified small business stock, and stock of most startups qualify as qualified small business stock.
THIS IS HUGE, and Section 1202 cannot be used to exclude gain from the sale of interests in LLCs. Note that some types of businesses including restaurants are not eligible for Section 1202 gain exclusion.
3. LLCs Can Complicate Investor Tax Situations
Investors frequently do not want to complicate their personal tax situation by becoming a member in an entity taxed as a partnership, and LLCs are most frequently taxed as partnerships. Members of LLCs taxed as partnerships:
- Receive a Form K-1 from the entity which allocates income and losses to the member;
- Members will be taxed on the LLC’s income even if no cash is distributed to you to pay the taxes;
- The investor’s ability to file its own tax return is dependent on receipt of the K-1, and if there are problems with the K-1, the investor could have to amend its tax return; and
- If the startup has an active trade or business and does business in other states, investors may become subject to income tax in those other states, which would obligate them to file in a tax return in multiple states.
4. Many Investors Can’t Invest in LLCs
Some investors (such as venture funds) cannot invest in pass-through companies because they have tax-exempt partners which do not want to receive active trade or business income because of their tax-exempt status. Many accelerators also require startups to incorporate as a C corporation prior to being accepted into the accelerator program.
5. Many Investors Prefer the Familiarity and Simplicity of Owning Stock in a C Corp
Investors are less familiar with LLCs than corporations, so they typically have to spend more time on diligence reviewing the underlying documents before deciding whether or not to invest. This increases their due diligence costs and requires them to spend more time understanding the startup’s entity when it could use that time to better understand the startup’s business and prospects.
Investors in early stage businesses usually just want to make an investment, acquire stock, and not have any intervening tax complications (like a Form K-1 and potential taxation in other states) until the stock is sold and there is a capital gain/loss event.
6. Convertible Debt Can Be Complicated and Have Negative Tax Consequences
One of the most common initial funding methods to raising capital for startups is through the sale of convertible promissory notes, but notes must be structured differently when issued from an LLC taxed as a partnership to avoid negative tax consequences.
If not properly structured, the conversion of the note itself can result in phantom income (e.g., taxable income without any receipt of cash) to the investor. Also, if the startup does not make it, then the founders may have to recognize forgiveness of debt upon the dissolution of the LLC.
7. Raising Capital Is More Difficult to Through an LLC
Raising additional capital through an LLC is much more difficult than raising a next round through a corporation. LLC agreements are more difficult and complex to prepare than their corporate counterparts.
Additionally, you can hit upon sticky and highly complex tax issues in the LLC context that just don’t exist or arise in the corporate context. In contrast, most financings are based on widely used forms of agreements that are set up for C corporations, which reduces the complexity and legal costs of raising capital.
8. LLCs Are Generally Obligated to Make Tax Distributions to Members to Cover Tax Obligations Arising From the Allocation of the LLC’s Income to Its Members
As noted above, LLCs do not pay tax on their earnings and instead allocate the earnings to the members of the LLC via the K-1. If a startup is fortunate to have income, then investors are likely to include obligations in the governing documents of the LLC that it make distributions to cover the federal and state tax obligations stemming from the allocated income at the highest tax rates of the members.
This obligation can result in the LLC having to distribute a significant portion of earnings to its members. In contrast, C corporations are currently only subject to a low federal tax rate of 21%, which means they can actually save more cash to use to grow the business.