We are frequently asked the “choice of entity” question for startup companies; that is, whether a client’s newly-formed company should be an LLC or a corporation. Putting aside that LLC’s can elect to be taxed as C or S corporations, the question traditionally translates into tax lingo as a choice between taxation as a partnership versus a C corporation. Now, we tax lawyers love partnerships for the same reasons kids love Legos®, but they are far from optimal for every startup. Every client situation is different, but generally an LLC may be a good idea if the client may want to do any of the following:
1. Distribute operating profits.
Instead of solely a capital appreciation investment, the company will be a “cash cow,” generating operating profits and distributing cash to owners. Notoriously, a C corporation would pay a corporate-level tax (up to 35%), and the shareholders would pay a shareholder-level tax (up to 23.8%) on their dividends. (That’s around 50% before state taxes. Ouch.) If the company were an LLC, it would allocate profits to the members, who would pay a single level of tax, up to 39.6%, with no additional tax if and when the profits are distributed.
2. Exit via asset sales or partial liquidity events.
The C corporation’s “double tax” problem is even more dramatic in the context of capital transactions rather than operating profits. There’s no capital gains tax break for C corporations, so if a liquidity event involves the company’s sale of assets, shareholders face the aforementioned 50% effective tax rate. On the other hand, an LLC would pass the capital gain through to its members, whereupon individual members would only pay the long-term capital gains rate of 23.8%. Most shareholders plan to avoid this problem by selling their stock for one level of long-term capital gain, but a stock sale may not be an option. Buyers may insist on an asset purchase, either for the future tax benefits or to avoid unknown or unwanted liabilities. Additionally, the company may face “partial liquidity events,” where the company separately monetizes some but not all assets. Examples include an investment pool with multiple portfolio companies, a company with multiple divisions or lines of business, or an entity holding intellectual property with multiple applications or fields of use, each of which may be developed and financed through a separate subsidiary.
3. Use tax losses.
Most startups operate at a net loss during their early years (if not their whole lives). A corporation’s losses do not pass through to the shareholders, but rather accumulate as “net operating losses.” NOLs may be carried forward to offset future net income for up to 20 years, but their use may be subject to limitations under the alternative minimum tax (AMT) or rules governing 50%+ ownership changes. An LLC’s losses pass through to the members and may be used to offset other taxable income. This can be a significant benefit – if the member can utilize the losses. Unfortunately, pass-through losses are subject to an array of limitations relating to basis and capital accounts as well as the “at-risk” and “passive activity” rules. In most circumstances, individuals must both (i) contribute their own capital and (ii) be active in the business to benefit from an LLC’s tax losses in the short-term.
4. Use equity as compensation or deal consideration.
In terms of equity compensation for key employees, corporations must choose between granting stock (tax now, capital gain later) or options/phantom stock (tax later but it’s ordinary income). LLCs may issue “profits interests” — potentially the best of both worlds (tax later at capital gains rates). Further, if the startup envisions acquiring other companies with equity, sellers may only receive tax-deferred corporate stock in limited circumstances (e.g., tax-free reorganizations or when the target shareholders take control of the buyer). It is much easier for sellers to receive tax-deferred LLC interests as deal consideration.
5. Implement complex economic structures.
LLCs and other tax partnerships are great for housing complex economic deals among founders, investors, and other equity owners. Examples include multiple tiers of priority distributions and returns of capital, carried interests, different profit splits for particular LLC assets, clawbacks, subordinated common interests, etc. Many of these concepts can be incorporated into a corporate charter with different classes of stock, but only clumsily.
6. Change your mind.
The flexibility of LLCs generally permits do-overs. If you’ve transferred valuable property to an LLC, the company can generally transfer it back to you tax-free. If company is an LLC and wants to convert to a corporation (or elect to be taxed as a corporation), that’s generally tax-free, too. Vice versa? Not so much. Both a transfer of property back to the contributor and the conversion of a corporation into a partnership or disregarded entity are generally taxable events. LLCs also let you change allocations of profits and losses for the year any time before the original due date for that year’s partnership tax return (usually April 15 of the following year). You may want to heed the Book of Common Prayer’s admonition about marriage — a C corporation should be entered into “reverently, discreetly, advisedly, soberly, and in the fear of God.”
On the Other Hand…
Even if a startup company could benefit from pass-through taxation, there are reasons one might affirmatively prefer C corporation status. Most obviously, the administration and accounting are fairly simple; for early stage companies, simple = good. Further, for overlapping reasons, tax-exempt and foreign investors (and the venture capital funds in which they invest) generally prefer owning corporate stock to LLC interests. So-called “qualified small business stock,” which can be sold with no federal tax at all if held at least five years, is only available for the stock of C corporations. Last but not least, executives holding LLC interests may be treated as “self-employed,” which implicates additional complexity and compliance burden. (See here for further information on the “self-employed problem.”)
All planning in life is essentially a prediction about the future. The right choice of entity for a startup company requires reasonable predictions about profitability, expected liquidity events, the usefulness of tax losses, the benefits of tax-deferred equity for compensation and acquisitions, the complexity of the economic deal, and the possibility of changing one’s mind. Weigh these factors against both the administrative complexity of partnership taxation and any affirmative reasons to prefer C corporation status.