February 24, 2011 13 Comments
You are preparing to form a legal entity for your start-up, and someone asks if you plan to form a C-Corporation or a LLC (note: depending on the state where you file your incorporation papers, you may elect a S-Corp instead of a LLC – some states still do not have the LLC structure as an option). If you don’t already know, you need to figure out which suits you the best before moving forward. The choice matters and you should make an informed decision.
So, what structure is best for your Company? The simple answer is it depends (sorry). If you want the “cliff notes” version it is below. Details then follow. The simple fact you are reading this post on CapGenius.com means the answer is probably a C-Corp as you will understand below.
“Cliff Notes” Version:
C-Corp: You are planning to raise outside capital from a group of investors, believe your company will grow to be a big business and potentially go public one day, or you’d prefer to have all taxation handled at the corporate level instead of passed thru to individual shareholders including yourself.
LLC: You expect your business to be smaller and not have as many shareholders, and to raise little (if any) outside capital. You do not expect to go public but think it is more likely you will want to pay the profits made by the company out to shareholders on a regular basis.
The Gory Details:
Still can’t decide? We’ll define each entity type in more detail which hopefully helps with your decision making.
LLC – Limited Liability Company. These entities were created to enable business owners to set-up a legal entity that provides them individual legal and financial protections (assuming you do not co-sign for the LLC’s liabilities) while maintaining a tax reporting structure that allows the business owner to record profits and losses on their personal taxes. As such, LLC’s are considered “Pass Thru” entities for tax purposes, meaning that the taxable profits or losses for the business are passed thru to the business owners, who record these as part of their personal tax filings. The LLC does not pay corporate taxes for profits and does not accumulate losses for future tax offsets. All of this is passed thru to owners.
The LLC structure is typically best for smaller companies where there are a few owners who are actively involved in the business operations (owners of an LLC are divided into active and passive owners, and passive owners receive substantially fewer tax benefits from an LLC structure. To be considered “Active” you have to be meet the IRS’s definition of being meaningfully involved in the operations of the business). LLC’s in most states are limited in terms of the number of shareholders they can have, although this is changing and there are ways around these limits, but again, LLCs are designed for smaller businesses so as you grow and your shareholder base grows, you may run up against some of these constraints.
LLC’s are also a good choice in situations where you expect the company with have significant profits and you plan to pay those out to shareholders on a regular basis. Because they are “Pass Thru” entities, LLC’s are not taxed for the profits and instead this is done at the individual owner level. Therefore, any cash from profits in the LLC has been paid for in terms of taxes already by the owners, and can be distributed to owners with no additional tax due. This is different from a C-Corporation that faces what is known as “Double Taxation” in that the company pays taxes for its profits, and then shareholders pay taxes for any distributions (dividends) paid to them. It is important to note that LLC’s do not have to distribute profits to shareholders. You can elect to keep profits in the company instead to reinvest in the business (or just keep for a rainy day). Each holders share of these profits is tracked in their capital account (part of the equity piece of your balance sheet).
We do not have data to show it, but have heard from some folks that they believe LLC’s get discounted values to some degree in an acquisition, in particular if the acquirer is a C-Corp (note: virtually every public company in the US is a C-Corp). There are two plausible arguments for this view. First, because LLCs are not taxed, they are more likely to have some funky stuff going on when it comes to capital accounts, retained earnings, etc. Because C-Corp finance teams do not understand LLCs as well, they could be understandably cautious, which may impact the valuation paid. The second reason is that it is perceived as being easier for a C-Corp to buy another C-Corp, whether it is the process of taking on outstanding stock options, handling tax matters for the stub year of the acquisition or other factors, there is probably some reasonable argument here. Again, we do not have data to back this up, but it is worth mentioning as you consider the best structure for your business.
One final note on LLCs. If you have any plans to raise money from institutional investors, DO NOT form a LLC. There is a simple explanation for this. Most venture funds are prohibited from investing in LLC’s because these entities can create UBTI (unrelated business taxable income) for the venture fund, and therefore for the funds limited partners. The majority of venture fund limited partners are non-profit entities, and one of the easiest ways to screw up this classification is to receive UBTI. As a result, venture fund documents go to great lengths to ensure they will not be in a situation where they might take on UBTI. Before you write a comment below, yes, you are correct, there are plenty of examples of venture firms investing in LLCs (wait, but you said….). HOWEVER, in these cases, the funds actually invested in something called a “blocker corp”, which is a C-Corp formed for the express purpose of investing in a LLC. This “blocker corp” effectively blocks UBTI from coming into the fund, because it is handled within the blocker corp’s C-Corp structure. So, yes, they CAN make an investment in an LLC, it is a pain in the ass for venture funds to do this and they would greatly prefer you have a C-Corp. We’d also argue that going in to pitch a venture fund with a LLC structure will show you as being somewhat naïve about corporations and venture financing, which may not be a major knock, but is still a knock. Given that, why provide a possible reason for a potential investor to look elsewhere?
C-Corporation. C-Corporations are what we think of as “regular” business entities because these are the types of entities we see and work with every day. C-Corps are taxable business entities, meaning that each year they report their profits/losses and pay taxes (state and federal) when they make a profit, and record a tax loss carryforward when they have a loss (these can generally be applied against future year profits for tax purposes). Shareholders in C-Corps have no tax implications from profits or losses as a result of owning shares in the entity, and would only have to pay taxes if they were to receive a dividend payment from the company or were to sell their shares for a profit. In addition, the ‘Corporate Veil’ of C-Corps is very strong in legal situations, meaning it is virtually unheard of that a shareholder of a corporation would have any legal liability for the actions of the business by virtue of simply being a shareholder. While LLCs have similar protections, they are less tested in the courts and because these entities are often related to personal businesses, it is in some cases possible for plantiffs to “pierce the corporate veil”. There is a vast amount of legal precendent for C-Corporations, which is an important consideration, especially as you business grows and the likelihood of some jerk trying to bilk money out of you for some bogus legal claim increases (do you get the sense we do not like trial lawyers?)
The primary negatives for a C-Corp is that they are somewhat more costly to maintain from a legal and tax filings perspective, and face “double taxation” when distributing profits to shareholders. This second piece is the most important, and is best explained with a quick example. Take a company that pays 25% in taxes on every dollar of profit, with shareholders who each pay taxes at a 30% effective rate. The company reports profits of $1,000 for the year, and pays $250 of that in taxes. The company decides to pay the remainder to shareholders, so pays out $750 in dividends. Shareholders report these dividends and income, and are taxed on them at the 30% rate (not at the lower Capital Gains tax rate), so of the $750 in dividends paid out, $225 goes to pay taxes. So, with a C-Corp, of the $1,000 in profits, $475, or 47.5% is paid in taxes. If the entity were a LLC, the business would pay no tax on the $1,000 profits. Instead, individuals would pay taxes on these profits at their personal tax rate, so in this example, $300 would go towards taxes, and the other $700 would be paid to shareholders. This is a 17.5% tax hit for having a C-Corp structure, which is big (and in our view an absurd process, but we doubt this gets changed anytime soon, or ever).
Here is the good news. If you are planning to raise venture capital or money from Angel investors, it is unlikely you will ever pay dividends anyways, so you should not let the double taxation issue bother you too much. Investors expecting to make multiples on their initial investment are going to have a hard time earning an acceptable rate of return based on dividend payments. While every preferred financing structure we have ever seen has dividends as part of the deal, these are non-cumulative (or should be) and are really only in place as a defense mechanism for investors (to prevent common holders from paying out all of the capital in a business to themselves).
On balance, we would recommend you go with a C-Corp unless you are a small business or have a small group of owners. This is one to discuss with your co-founders and legal advisors, but if you would check any of the boxes in the quick summary above for C-Corp, we’d recommend going that route.
Quick note: It is possible to convert an entity from a LLC to a C-Corp. It can be a pain to do this, but it can be accomplished, so don’t worry if you are already formed as a LLC, you can change it later on – we’d recommend you plan to do it in conjunction with an outside financing round as it is not a cheap process. Letting potential investors know you are a LLC but plan to convert with the financing can help with the slight knock we think you’ll get for being a LLC in the first place.
Second quick note: If you plan to self-fund the business for a couple of years before raising outside capital and are into optimal tax planning (and have a good tax and corporate attorney), consider structuring as an LLC in order to recognize early year losses personally before you raise outside money. Plan to convert when your business starts to form a profit or when you raise outside capital (whichever comes first). This only works if you are self funding with a meaningful amount of money, and will require extra work (and legal fees), so we doubt this is the right path for about 97% of the people reading this article, but we like tax optimization so figured we’d mention it for the 3% of you out there.