The most common question I’m asked by founders of startups who hire us as their personal financial planners and fractional CFO is what type of entity should they form. The reason they ask this is that they get conflicting advice from their CPA, their mentor, and other entrepreneurs in the same industry.
There are a ton of different choices but one clear winner: the C Corporation for most tech firms.
As you’re launching your business and you’re working endlessly for what seems like peanuts, the last thing you want to think about is how to structure your company. If someone was to ask you why you chose the structure you did, most would probably say there are more important things to spend their time on.
…how wrong they are.
When we talk to founders, most say they want a simple, easy-to-manage business structure that’s low cost and provides the fewest distractions from the thousands of other concerns they may have as they strive to get their business off the ground… but setting up an entity is necessary if founders ever want to attract investment and limit personal liability.
When it comes to creating an entity, the decision you make has an impact on:
- Personal Liability
- How attractive you are to invest in
- The taxes you’ll owe on profits
The most common reason people create LLCs is that they avoid the dreaded “double tax” associated with a C Corporation. You may have heard about it but aren’t really sure how it works.
What the double tax refers to is that the profits of a C-Corporation are taxed first at the corporate level and second, once those profits are distributed to shareholders in the form of dividends.
The people who dislike this aren’t wrong. That’s a lot of taxes. The government is definitely getting its fair share in this scenario.
The reason they’re oftentimes wrong is that most startups aren’t profitable for at least a few years and those that reinvest all of their profits back into the growth of the company (or they don’t and they don’t grow as fast as a result…). For this reason, startups are rarely (if ever) subject to double taxation.
Why Shouldn’t a Founder Choose to Form an LLC?
For tech and growth companies planning to follow the normal path of regular and ongoing equity grants to their employees to help retain them, go through multiple rounds of financing, seed funds, and all the while reinvesting as much capital as possible into the business with the goal of selling to amazon or some major tech firm someday in the future… LLCs are typically not the way to go.
Below are a few of those reasons.
1. Equity Compensation Is Complicated in an LLC
Since Startups rarely can afford to compensate their employees as well as major companies like those that are part of FAANG, equity is oftentimes a big portion of total compensation for their employees. Providing equity compensation when you own an entity that’s taxed as a partnership is much more difficult, complicated, and expensive to draft and administer than when you own a C-corporation.
The equivalent of a stock grant in an LLC is a “profits interest” which, when issued, often makes the LLC “book up” the capital accounts of the owners prior to granting the profits interests. This same complication occurs with options or warrants to acquire LLC interests. Additionally, if a W-2 employee receives a profits interest, then she will be treated as a partner for tax purposes and can no longer be treated as a W-2 employee.
2. LLCs are Not Eligible for Section 1202 Gain Exclusion
Section 1202 is one of the biggest tax incentives for founders and investors alike. It allows you to exclude up to 10 million in capital gains from the sale of qualified small business stock. Fun fact? Most small business stock qualifies.
This tax benefit could be worth literally millions to some people and it cannot be used to exclude a gain from the sale of interest you own in an LLC. Keep in mind, that not all owners and investors in C- Corporations get this benefit. Talk to a tax expert before trying to claim it.
3. Investors want simplicity in their tax situation. Investing in an LLC complicates (not simplifies) your personal taxes.
Investors like simple tax situations (not complicated). LLCs are most frequently taxed as partnerships and investors in partnerships don’t have simple tax returns. Members of LLCs taxed as partnerships:
- Receive a Form K-1 which details their proportionate interest in income and losses
- Will be taxed on the LLC’s income even if you don’t get paid any of it.
- The investor’s ability to file their own tax return is dependent on receipt of the K-1. K1s can be late and may need to be amended. If that’s the case, the investor would have to refile their tax return which can be a hassle.
- If your startup has active trade or business in multiple states, your investors may have to file taxes in other states than the one they live in which would obligate them to file a tax return in multiple states.
4. Many Investors Prefer the Familiarity and Simplicity of Owning Stock in a C Corp
Investors are less familiar with LLCs than corporations, so they typically have to spend more time on diligence reviewing the underlying documents before deciding whether or not to invest. This increases their due diligence costs and requires them to spend more time understanding the startup’s entity when it could use that time to better understand the startup’s business and prospects.
Investors in early-stage businesses usually just want to make an investment, acquire stock, and not have any intervening tax complications (like a Form K-1 and potential taxation in other states) until the stock is sold and there is a capital gain/loss event.
5. Raising Capital Is More Difficult Through an LLC
Raising additional capital through an LLC is much more difficult than it is through a C-Corporation. Why? LLC Agreements are more difficult and complex to create and prepare than it is via a C-Corporation.
In contrast, most financings are based on widely used forms of agreements that are set up for C corporations, which reduces the complexity and legal costs of raising capital.