Corporation vs LLC for Startups
| Tweet |
The general consensus is that start-ups seeking venture capital should incorporate as C-Corporations, not LLCs. Interestingly, an LLC is a highly customizable entity through which a company could set up structures similar to a C-Corp. An LLC can create membership interests akin to corporate stock, including different classes of ownership with customizable rights, and can even elect to be taxed just as a C-Corp. An LLC is generally easier to set up and easier to maintain because fewer formalities are required (with the caveat that more customization entails more work). With all this flexibility, why don’t emerging growth companies use LLCs more often?
The short answer is that investors prefer C-corps, primarily because of tax implications and a few other key considerations. To understand more, keep reading.
(1) Taxation
An LLC with multiple owners or “members” is taxed as a partnership by default. Each member reports his or her share of profits and losses on a personal income tax return. This can be advantageous in certain contexts, but can be problematic for outside investors because they are required to recognize income and pay taxes on it even when the company is reinvesting all profits back into the company. (Note that an LLC can choose to be taxed like a C-Corp instead, but some of the tax benefits of C-Corps (linked to above) won't apply).
A C-Corp is taxed as an entity on its business income at corporate tax rates similar to income tax rates. If the company pays out dividends to shareholders, individual shareholders then pay taxes on their dividends at long term capital gains tax rates. Since emerging growth companies rarely pay out dividends (they are usually reinvesting profits into the company instead), this “double taxation” is unlikely to apply. The C-corp thus enables and encourages businesses to retain earnings rather than passing all earnings through to shareholders, and passive investors will not pay taxes until they actually receive the fruits of their investments.
[Check out our entity taxation calculator to compare C-corp and LLC taxation]
(2) Special Tax Considerations for Investors.
LLCs can create problems for institutional investors in particular. Many venture fund limited partners are tax-exempt non-profit entities and investment in LLCs triggers UBTI (unrelated business taxable income), which can undermine their classification as tax-exempt. A possible way to structure around this issue would involve setting up a special purpose entity, for example, using a “blocker” corporation that receives investment and then passes it on to the LLC. Setting up such entities is a big hassle and extra expense, creating an additional hurdle for companies to receive funding from venture funds.
Additionally, C-corp investments receive special advantageous tax treatment if the investment is “Qualified Small Business Stock.” There are specific parameters for eligibility for this treatment, but in essence, under Section 1202 of the Internal Revenue Code, an individual taxpayer can exclude 100% of the gains realized on the sale of QSBS stock (up to $10 million or 10 times the original purchase price) if the taxpayer holds the stock for more than five years prior to sale. The taxpayer can also defer recognition of gains if the taxpayer reinvests in QSBS within specified time parameters. This nice perk for investors only applies to investment in C-Corps, not LLCs taxed as partnerships.
(3) Investor Liability
There is a well-developed body of law and many precedent cases insulating the shareholders of C-corporations from being held liable for the business’ actions (“the corporate veil”). Similar laws apply to LLCs, but there are fewer case precedents, and in turn, potentially a bit more risk that a plaintiff could “pierce the veil” and hold shareholders personally liable.
(4) Stock Classes
C-corps have conventional structures in place for distributing different classes of stock. VC investors will typically seek preferred stock, which enables investors to secure special rights and privileges such as liquidation and dividend preferences, rights to board seats, pro rata rights to participate in future investment rounds to maintain their ownership percentage, adjustments of their purchase price when shares of stock of stock are sold at a price per share less than the price paid by earlier investors (anti-dilution), among other rights.
LLC’s do not issue stock, but can instead issue “units” or “ownership interests” in the company and set up preferential rights similar to preferred stock. However, this is bound to become complex and potentially quite costly as there is not a conventional model for implementation. Investors will not be familiar with the structure, creating more work on their part to review and understand investment terms, and there will be more uncertainty regarding what is judicially enforceable when working outside of the conventional structures.
Considering these investor preferences, and the practical ease of working within pre-established conventions, venture bound companies that have already formed as LLCs sometimes consider converting into C-Corps. Companies that are not seeking outside investors may find LLC tax treatment to be advantageous and those who want to creatively structure their business and ownership arrangements may effectively leverage the flexibilities of the LLC.