In the rapid-pace early stages of a startup, founders make daily decisions that could either be minor, or could significantly affect the trajectory of the startup’s future success. Most of these decisions are trivial. But there is one major decision that could significantly impact the future of the startup—the type of business entity used to form the company.
I am regularly approached by startup owners wondering whether to choose a C Corporation, an S Corporation, or an LLC (a limited liability company). This is by far one of the most significant choices a new startup can make because it may profoundly impact the ability to raise capital, which in turn will impact the future direction of the company.
When I work with entrepreneurs and their startups to determine what type of business entity they should choose, I typically recommend an LLC rather than a corporation for a number of reasons (e.g. organizational simplicity, costs, pass-through taxation, lack of complex corporate formalities, etc.). However, there are some instances when a corporation is the best type of entity: tech startups or other startups who expect many investors and large-scale growth (e.g. companies aspiring to be the next Snapchat, Facebook, Lyft, etc.).
What are the most likely types of business entities for startup incorporation?
To understand why a lot of thought should be given to business entity selection, it is important to first understand the three major types you should choose from. All three types offer the owner(s) limited liability for their business’s debts and obligations. What differentiates these types of entities from each other—and what is most significant to investors—is their federal income tax characteristics.
LLC: LLCs are, like S corporations, “pass-through” entities, meaning that their owners (also known as members) pay taxes on the portion of the LLC’s income that is allocated to them based on the LLC’s operating agreement. For LLCs with multiple members—which is what happens when investors play a role—the members of the LLC are treated as partners for federal income tax purposes.
C Corporation: Unlike S Corporations and LLCs that are treated as a partnership, C Corporations are subject to state and federal income taxation on its net income—that is, the income that is realized after expenses (including salaries) are paid out. Shareholders are not subject to federal income tax unless the corporation pays them in the form of dividends, distributions, or salary. However, since dividends are paid from net income, shareholder dividends are effectively taxed twice—once when the corporation pays tax on its net income, and again when the shareholder gets the dividends.
So, why not an LLC?
Tech companies that intend to raise capital to grow their companies often find it far more challenging to pursue investors if their company is an LLC. Here are four reasons why investors sometimes shy away from startups of the LLC form:
Most investors dislike the tax consequences of LLCs. Most investors would rather not complicate their own tax situation by becoming a member of another business entity (i.e. an LLC) that is taxed as a partnership, because as a partner, they will be taxed on the entity’s income even in years when no cash is distributed to them personally.
Many investors cannot invest in LLCs. Some investors, such as venture capital funds, can’t invest in pass-through companies such as LLCs, because the VC fund has tax-exempt partners that can’t receive active trade or business income due to their tax-exempt status.
Investors are potentially taxed in other states. If the business has an active trade or business in other states, passive investors may become subject to income tax in those other states, too. A similar thing happens when non-US persons invest in US LLCs. This situation is a significant turn-off for investors.
Investors tend to prefer owning stock in a C-Corp. Investors in early-stage businesses usually just want to make a simple investment, acquire a capital asset (the stock), and avoid intervening tax complications until the stock is sold and there’s a capital gain or loss event to recognize.
About the Author:
Dallas P. Verhagen is a business attorney and a partner at Verhagen | Bennett LLP. To learn more about Dallas, please click here.
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© 2017 Dallas P. Verhagen — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.