Mark J. Graffagnini, Esq
Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Silicon Bayou News, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.
One of the first questions I receive from founders and entrepreneurs in general is “what type of entity should I use? LLC or C-Corp?” There are several complicated issues that influence the entity choice for any particular business. If an entrepreneur plans to raise venture or angel capital (particularly, in the technology world), then the answer is usually going to be to form a C-Corp. In other contexts, however, an LLC may be the appropriate entity. Below are some factors to discuss with your attorneys, co-founders and other advisors as you consider this question.
Tax Issues
C-Corps. A C-Corp is a separate taxable entity independent from its stockholders (the owners of the C-Corp). So, income from the operations of a C-Corp are taxed twice: once at the corporate level on the corporation’s taxable income and a second time at the owner or stockholder level on dividends or distributions. In addition, C-Corps often must pay higher state franchise taxes than LLCs or S corps (although LLCs still need to pay state taxes or minimum fees).
Although no one wants to be taxed twice on one set of earnings, the fact that C-Corps are technically subject to “double taxation” does not really end the analysis. In the startup context, many companies do not plan on paying their shareholders, investors or founders any of the income the company makes for several years.
Where a company does not pay dividends, then individual owners of the company will not have any tax liability on the earnings of the corporation (this is not the case in an LLC). If a C-Corp generates net operating losses rather than net income, these are carried forward to offset future corporate taxable income. However, such operating losses may not be used to offset taxable income of the individual shareholders (as they are in an LLC).
LLCs. LLCs are considered “flow through” entities under the tax laws. This means that taxable income earned by the entity is passed through to individual owners of the LLC. In other words, income from operations of an LLC is taxed only once, at the member level. An LLC may elect to be taxed as a C-Corp, an S corp, or a partnership. LLCs have flexibility in terms of how taxes might be allocated among particular owners of the company. However, such flexibility is countered by increased compliance costs due to the application of complex partnership tax rules that also apply to LLCs.
One large deterrent to the use of LLCs in the startup context is the situation in which earnings by a young company will be reinvested into the company to fuel rapid growth. If the company earns income, but it does not make distributions to members, then this will result in the individual owners having to pay individual taxes on the earnings of the company directly out of their own pockets (unless the company makes “tax distributions” to the owners.
Financing & Fundraising
C-Corps. Most angel, venture and institutional investors strongly favor C-Corps. Period. The reasons they favor C-Corps are several. Some of the reasons include the fact that they may have separate classes of stock, allowing for the creation of various levels of preferences, protections, and share valuations. LLCs can easily include various types of units or levels of membership interest similar to classes of preferred stock, but the expense and complexity of drafting documents that reflect that easily exceed the expense and complexity required to achieve the same result in a C-Corp. C-Corps are most often and most easily chosen for certain types of exists, such as an IPO. Although some companies begin as LLCs to allow individual founders to pass-through losses from early operations, I have rarely seen a single investor (angel, strategic or otherwise) who has not required that an LLC convert into a C-Corp prior to investing in the company in the past year of conducting financings for companies and investors alike.
LLCs. LLCs are sometimes preferred for companies that expect to run themselves as partnerships or very closely nit businesses. To this end, LLCs often require complicated operating agreements that may render the operation of the LLC undesirably difficult with a high number of members. LLCs are often unattractive to tax-exempt venture fund investors because their investment in a flow through entity may produce unrelated business taxable income. This could subject certain types of offshore limited partners or pension funds to tax regulations which would prevent them from investing in the fund and potentially expose the venture or angel fund to a variety of issues. Finally, investors simply may be less familiar with LLCs and therefore less willing to invest in them.
Management and Governance
C-Corps. Governance of C-Corps is well defined by principles of corporate law. Governance of the corporation is vested in the board of directors of a C-Corp. Typically, stockholders have certain limited rights. Management (president, CEO, for example) is accountable to the board of directors and therefore has the ability to transact business without stockholder participation in each decision. However, the law requires that corporations pay attention to certain formalities such as meetings of boards of directors, maintenance of bylaws, corporate minute books, stock ledger books, separate bank accounts, etc.).
LLCs. LLCs operate often more informally then C-Corps. Management of LLCs can be vested in the members themselves (think traditional partnership) or in certain managers designated to have authority (similar to a corporate structure with a board of directors). LLCs are not generally bound by the same degree of legal rules and formalities that C-Corps are held to by law, but they generally deal with this in the startup context by adopting very similar rules to C-Corps to reduce investor uneasiness and to provide for clean governance rules. The LLC is a relatively new form of entity, so courts have been inconsistent in determining whether to apply principles of C-Corp law, partnership law or a hybrid law to determine the requirements of LLC management and governance. This uncertainty can sometimes provide a counterbalance to the flexibility people find desirable in an LLC.
Equity Compensation
C-Corps. Businesses that desire to offer incentive stock options (called “ISOs”) to employees choose C-Corps. ISOs allow employees to defer tax on the equity compensation until they sell the underlying stock. Additionally, C-Corps. may offer certain fringe benefits to employees that are tax-deductible to the company and also tax-free to the employee. Stock option plans are commonly used and widely understood. Generally, stock option plans may be administered by the board of directors in consultation with the company’s HR representative with relatively little expense or complexity.
LLCs. While an LLC may reward employees by offering them membership interests in the LLC, the equity compensation process is awkward and may be unattractive to employees. Furthermore, LLCs are not able to offer certain forms of equity compensation available to C-Corps., such as incentive stock options. Many practitioners (accountants and attorneys) are highly inexperienced and reluctant to implement employee equity incentive programs for LLCs. Also, once an “employee” receives actual ownership in an LLC, that “employee” becomes a member of the company and will receive a K-1 rather than the typical W-2 that employees receive. Various types of LLC incentive plans will be discussed in future posts.
Readers: Submit comments or questions below or email Mark directly at mg@graffagninilaw.com. Your question could become the subject of future posts.