Few decisions are as important as choosing the right entity for your nascent startup. This decision is so difficult partly because at the early stage of launching a business, there are so many unknowns. Ultimately, founders should reflect on (a) corporate culture, (b) management style, (c) need for institutional funding and (d) inclination to reinvest profits into their business. These four considerations are key to determining which entity is the best fit.
The LLC
The LLC is the most popular business entity. For every corporation, two LLCs are formed in the United States. Its hallmarks are flexibility, lack of corporate formality and pass-through taxation.
A. Flexibility & Lack of Corporate Formality
The LLC statutes give carte blanche to businessmen to write their own rules and procedures and run the entity as they see fit. For this reason, it is a great choice of entity for small businesses and startups built as small businesses (( By that I mean, a self-funded business with 5 owners or less and less than 5 employees, with no institutional funding needed in the emerging phase)). For this type of startup, decisions are often reached by consensus (as opposed to formal meetings). An LLC can further the business goals of these startups by allowing decisions to be reached informally, on a consultative basis.
However, the greatest benefit of the LLC (its flexibility) is also the source of its greatest danger, and the reason why LLCs are so often misused. When an LLC operates without operating agreement or with one snagged on the Internet, serious pitfalls loom the LLC (to which a corporation would otherwise be immune). The reason is that LLC are meant to be “creatures of contract”: the operating agreement is supposed to set the internal rules, not the LLC statutes. So if these internal rules fall short, the startup can get into real trouble. The LLC statutes likely won’t fill the gap, thereby plunging the LLC in uncertainty and leaving it vulnerable to lawsuits.
In short, An LLC is as good as its operating agreement. It is great for small businesses type startup, where decisions are made informally based on consensus, but require taking the time to work with a lawyer to establish the startup’s internal rules. A thorough and well-drafted operating agreement can go a long way toward reaping the benefits of LLC ownership by creating a customized governance structure. Conversely, without a thorough agreement, the LLC is just an empty shell, a lawsuit waiting to happen.
B. Pass through Entity
The LLC profits are not taxed at the entity level, they are passed through to its members who pay taxes at their individual level. In contrast, a corporation pays taxes at the business and individual levels. Shareholders pay taxes at their own level on dividends, resulting in a double tax. Generally, LLCs are subject to fewer tax liability but this varies depending on your particular circumstances. A consultation with a tax attorney or accountant would be well advised.
The C Corporation
The C Corporation is the entity choice of virtually all companies trading on the stock exchange. It’s copious formalities, predictable rules and procedures and, ability to efficiently raise and retain capital are the chief reasons to choose a corporation.
A. Prerequisite to Venture Capital Funding
The C Corporation is the only viable entity for startups seeking to raise V.C. or angel investors funding. The reasons are as follow:
1. Predictability. Corporate law, especially in Delaware, is long established and is composed of a sophisticated corporation statute and astute judges. In contrast, the LLC is a relatively new entity. Case law interpretating the LLC statutes and operating agreements is rather slim.
2. Simpler Tax Implication. When investors acquire stocks in a C corporation, they know when the tax event occurs (at exit, when the stocks are sold). Tax implications can be quite complex in an LLC. Its pass-through nature would impose on V.C and their investors income and loss recognition every year, which is not in their best interests.
3. Ability to Participate in Tax-Free Stock Swap. If both buyer and seller are C corporations, an acquisition of the startup is eligible for a tax-free reorganization under IRC Section 368 – whereas the same transaction would generate tax obligations with an LLC.
That said, an LLC or S Corp may make a lot of sense in a startup’s infancy. LLC and S Corp are easily converted into C Corp This requires some extra planning in the case of the LLC, with careful drafting “baking” the incorporation procedures into the operating agreement. And so “a best of both world” scenario can be achieved, especially when getting institutional funding is not a priority.
B. Double Taxation & QSBS Exemption
Although there is the potential for double taxation in C Corporation, startups that reinvest all their profits into the business do not suffer from double taxation. Hence, the risk of double taxation is inexistent as long as the startup is in a phase where it reinvests its capital. Conversely, an LLC or S Corp would be much better fit if profits were immediately disbursed.
Additionally, gain from the sell of certain Qualified Small Business Stock (QSBS) may be excluded from federal income tax as long as certain requirements are met, such as holding the stock for at least 5 years. This opportunity for great tax savings is only available to C Corp (however, IRC Section 1202 has expired and has not been renewed in 2015).
Overall, the C Corporation, is best when hierarchical, formal decision-making is needed, institutional funding is sought, and when capital will be accumulated and reinvested in the company. A C Corp is the gold standard of startups set for rapid human and financial capital expansions. But, it’s formalities can be an impediment to efficient decision making – and can seem absurd in a 2-3 shareholders corporation (( Although the undesirable formalities can be mitigated by properly drafting closed corporations agreements.)).
The S Corporation
An S Corporation is a great option. Like the LLC it is a pass-through entity, and like the C Corp it is subject to stringent internal and external formalities. The S Corp also has three unique restrictions:
- It cannot have more than 100 shareholders;
- Its shareholders must be US Citizens or permanent residents; and
- It can only have one class of stock.
One important tax benefit of the S Corporation is that a portion of the profits is not subject to self-employment taxes – whereas all profits are subject to it in an LLC. This can result in substantial tax gain. However, tax attorneys are needed at every step of the formation and financing process of S Corps, which obviously ramps up the cost of formation, at a time where startups’ resources tend to be scarce.
