What type of entity should I choose, LLC, C corporation, or S corporation?

Deciding whether you should organize as a C corporation, S corporation or limited liability company can soak up a lot of time and resources.  Some founders may spend more time on this question than is warranted given the inability to know for sure how quickly your business will grow, how much and which type of outside investment will be required, whether cash will be reinvested or distributed to owners, or whether you will sell the Company or go public – all of which are part of the analysis.  Tax rules are the primary source of the complexity, although management and liability issues under state law also make a difference.  

Founders tend to fall into two categories when dealing with this issue – those that , with their lawyers and accountants, carefully analyze the various tax rules against their expected growth and exit strategy and try to make the best decision under uncertainty  – and those that punt, opting to stick with the format used by most VC-backed technology companies  (C corporation) and spend their time and energy on growing their business.  

One reason venture capital firms generally will only invest in corporations because they usually have tax exempt investors who do not want to subject to unrelated business income tax (UBIT), which would be an issue with an LLC.  Moreover, VC members may not want to file state tax returns, or, in the case of foreign investors, federal tax returns.   VCs like some of the other advantages to C-corporations discussed below.   

For those that want to dive into the analysis, I discuss the major differences between C corporations, limited liability companies, and S corporations in the second half of this article.   Perhaps the best place to start the  analysis is to understand why most tech startups are corporations, and to consider what makes your company different, if anything.  If not, you may want to follow that model.   Since the C corporation is the predominant entity form for tech startups, documentation has become fairly standardized for corporate governance, rights among shareholders, equity compensation, and capital raises. 

The top level questions that will affect your choice of entity are these:

  1. Do you expect to take money from a Venture Capital firm or an institutional investor.   In this case, you will need to be a C corporation, although you may be able to start life with an S election while you bootstrap and only convert if it becomes necessary.
  2. Will you be a typical technology company that will want to issue stock options to employees, raise capital through preferred stock, and expect a typical technology company life-cycle in which all surplus will be reinvested into the company (no distributions to owners) which is grown until the company is acquired or goes public, These factors would push you toward the C corporation form.
  3. Alternatively, will your company be operated for its cash flows over a long period of time, not necessarily managed for a public exit.   In this case, a pass through entity such as an LLC or an S corporation may be preferable.

Those are the primary considerations.  For those that want to dig deeper into the minutiae, what follows is a more detailed discussion of the differences between C corporations, S corporations, and LLCs (taxed as partnerships). 

C Corporations.  The biggest downside of corporations is that they are subject to double taxation.  (The corporation itself is taxed on its profits, and shareholders are taxed when earnings are distributed to them.)   However, the downside is diminished if the company intends to reinvest most of its surplus cash for growth.  Moreover,  the C corporation can accumulate net operating losses, which may offset profits in the future or have value to an acquiring corporation.  C corporations can qualify for Section 1202 qualified small business stock, and for Section 368 tax-free reorganizations.

Limited Liability Companies.  Technically, LLCs are disregarded entities in the eyes of the IRS.  Under the Code, LLCs may elect to be taxed as a partnership, as a C corporation, or as an S corporation.  When people refer to the tax treatment of LLCs, they usually mean an LLC that has elected to be taxed as a partnership.  Taxed as a partnership, the LLC is a “pass-through entity” that is not taxed.  The members are taxed according to the amount of profits that are allocated to them per the terms of the operating agreement.  Allocations of profits and losses need not necessarily follow ownership percentages, they can be specially allocated per the terms of the operating agreement, although accounting and compliance gets more complicated when it does not.  Investors can offset their other income from their share of LLC losses.  Another advantage of partnership taxation is that appreciated assets  can generally be distributed to partners/members tax free.  (This can allow tax-free spin-offs of subsidiaries and other assets to the members.)  Appreciated property (such as developed software, for instance) can be contributed to the LLC tax-free (without a  “control requirement”).  Lastly, redemptions of membership interests are a deductible expense to the LLC.

S-Corporations.   Technically an S corporation is an election filed with the IRS, not a form of entity.  LLCs, as well as corporations can be taxed as an “S corporation”.  An LLC that makes an S election will be an S corporation in the eyes of the SEC, but it’s corporate governance matters will still be controlled by state law and the LLC operating agreement.  Like an LLC taxed as a partnership, an S corporation is a flow though entity with a single layer of tax.  S corporations convert easily to a C corporation.  (Actually they convert automatically to a corporation if the company does anything to blow its S election, such as exceed 100 shareholders, accept a foreign shareholder, or issue preferred stock.)  As with C corporations, Section 368 tax-free reorganizations are available. 

 An S corporation structure may result in the reduction in the overall employment tax burden.  One difference between S corporation taxation and partnership taxation is that owners of LLCs can not be employees of the company.   All member draws are subject to self-employment tax.  With S corporations, owners may be reduce employment taxes by taking part of their income in salary (and paying employment taxes on that) and taking the rest of their income as a distribution.  S corporation shareholders who are employees are taxed as employees and receive a Form W-2, not a Form K-1.   As long as the salary is reasonable in the eyes of the IRS, the income taken as a distribution is not be subject to employment tax withholding. 

Traditional stock options are available for S corporations, as long as the exercise price is a fair market value and doesn’t have any unusual terms that would cause it to be characterized as a another class of stock. 

In summary , here are reasons you may choose one entity form over another:

 C corporation because:

  • Predominant model for tech start-ups (equity offerings and IPOs)
  • VCs usually won’t invest in LLCs
  • You will have foreign, corporate, or non-profit investors
  • Retention of earnings/reinvestment of capital
  • Qualified small business stock (Section 1202)
  • Section 368 tax free reorganizations available

LLC (taxed as partnership) because:

  • Single level of tax
  • Flow through entity that allows: multiple classes of units, foreign members, over 100 members
  • Investors can use operating losses
  • Business will be operated for cash flows
  • Tax-free distributions of appreciated assets
  • Tax-free contribution of appreciated property without “control requirement”
  • Special allocation of tax attributes (such as specific gain, loss, income or deductions)
  • Redemption of partnership interests are deductible expenses of the LLC

S corporation because:

  • Simple flow through entity with single level of tax
  • Easy to convert to C Corporation
  • Can minimize employment taxes
  • Investors can use operating losses
  • Business will be operated for cash flows
  • Traditional stock options are available (as long as exercise price is at market value)
  • Section 368 reorganizations available

But, S corporations are limited to 100, domestic, non-corporate shareholders, one class of stock.  Shareholder redemptions are not deductible.  Lack of ability to allocate profits, losses, attributes other than pro rata.

 

Speak Your Mind