Startup Series: Entity Selection

One of the questions that founders often struggle with at the outset of their venture is what kind of business entity to start out with:  LLC?  C-Corp? S-Corp?  There’s no one-size-fits-all answer:  When choosing the legal form that your business entity will take initially, founder will need to consider tax efficiency, impact on future financing, legal costs, and familiarity for various stakeholders and investors. Here’s our primer; a chart summarizing key points is at the bottom.

The Bottom Line: C Corps are usually the best choice if founders want to realize their profits by selling their shares after growing the business using VC financing with the expectation that the equity will be broadly distributed. On the other hand, if the founders anticipate that they will reap their profits in the form of distributions of income from the business (including gain from an exit structured as an asset sale), they should consider using an S Corp or an LLC.  A middle way is to start out with an LLC, and convert to a C-Corp if and when it becomes prudent.

C Corporation

The major downside with C Corps is that they are double-taxed: the C Corp reports and pays taxes on its income . . . and then shareholders pay taxes again on distributed income. Shareholders report losses of their investments as capital losses only when they dispose of their shares, and individuals who are shareholders may use capital losses to offset only capital gains (and small amounts of ordinary income).

While double-taxation is a serious concern, there are many factors that favor adopting the C Corp from from the outset (or converting to it from an LLC):

• Investment: Many VCs will only invest in C Corps—many VCs are partnerships, and partnerships cannot invest in S Corps. Furthermore, investing in an LLC can cause problems for any tax-exempt or foreign VC partners. Finally, VCs will almost always demand preferred equity, which is not permitted in S Corps (but can be created in LLCs).
• Equity Incentives: Equity-based compensation is simplest with C Corps: C Corps and S Corps (but not LLCs) can grant tax favored incentive stock options (ISOs). But tax-favored does not equal tax-free: founders should consult their accountants.
• Small Business Stock: Only shares of C Corps can qualify as small business stock (SBS): disposal of small business stock at a loss can treated as an ordinary loss within certain limits.
• Tax-free Reorganizations: After certain requirements are met, shareholders of a C Corp (or an S Corp, but not an LLC) can exchange their stock for stock of an acquiror without being taxed in a tax-free reorganization—they would then defer reporting their gains until the time that they dispose of the new stock.
• Reinvestment: Under certain circumstances, reinvested income of a C Corp can be taxed at a lower rate than reinvested income of an S Corp or LLC.
• Ease of Tax Filing: C Corp shareholders don’t need to file personal tax returns in all of the states in which the business has a tax presence.

C Corp Summary: Founders should consider the C Corp at the outset if they intend to grow by obtaining VC financing and motivating employees and consultants with tax-favored equity early on. But founders can also “wait and see” with an LLC:  while cash is scarce, they can avoid early double-taxation issues and report early-stage losses on their personal tax returns by using an LLC. The LLC can usually be converted to a C Corp later without triggering tax liabilities; conversion from an S Corp is more complicated from a tax perspective.

Note, however, that conversion from an LLC will involve additional expense, distraction, and delay—often in the middle of financing negotiations. Furthermore, conversion may negatively impact the value of a company in the eyes of some sophisticated investors such as VCs, given the increased layer of documentation and risk.

S Corporation

The S Corp avoids the double taxation of the C Corp, because the income and (for the most part) the losses of an S Corp are reported by the shareholders in proportion to their shareholdings. Distributions of income to shareholders are not subject to further taxation. But there are restrictions that make the S Corp appropriate only in narrow circumstances:

• Only Common Stock Allowed: The S Corp may only have a single class of stock—only differences in voting rights are allowed.
• Limited Number of Shareholders: An S Corp may not have more than 100 shareholders.
• Restrictions on Type of Shareholders: Shareholders must all be U.S. citizens or residents, or estates, certain types of trusts, or charitable organizations.

Founders will typically first have to decide between a taxable entity or a non-taxable/pass-through entity (i.e. between a C Corp vs. an S Corp or LLC). After settling on a pass-through, the factors that can favor an S Corp over an LLC are:

• Exit Strategy Versatility: As with a C Corp, shareholders can swap their stock for an acquiror’s stock in a tax-free reorganization. Also, it is easier for an S Corp shareholder to report their exit gains as capital gains rather than ordinary income by structuring their exit as a stock sale rather than an asset sale.
• Equity Incentives: Equity incentive arrangements are more complicated with S Corps than C Corps, but still more simple than with LLCs. Like C Corps (but not LLCs), S Corps can grant ISOs.
• Tax Benefits for Owner-Employees: Owners of S Corp stock who receive wages and distributions only have their wages subject to employment taxes. By contrast, owner-employees of an LLC may be subject to self-employment tax on their entire share of the LLC’s business income.
• Property Tax Benefits: S Corps may be eligible for local property tax exemptions that are not available to LLCs. This is important if the company will have a lot of inventory, machinery, or other personal (non-real estate) property.

S Corp Summary: If they qualify, founders should consider an S Corp if they want a simple arrangement that will avoid double taxation while preserving their ability to sell the business for stock of an acquiror on a nontaxable basis, maintaining their ability to motivate employees and consultants by granting ISOs, and minimizing employment tax issues.

Limited Liability Company

LLCs also avoid the double-taxation of C Corps: an LLC is treated as a partnership for federal tax purposes, meaning that the income and losses of an LLC are reported by the LLC’s owners along the lines laid out in the Operating Agreement. The LLC is more flexible than the S Corp but more complex.

If the founders want a pass-through entity, factors that may favor an LLC over the S Corp are:

• No Qualification Requirements: Like C Corps, LLCs can have multiple classes of owners, and may include entities and foreigners among its owners/investors (although foreigners may shun the LLC because of tax complications).
• Ease of Conversion: Because assets can pass in and out of an LLC without triggering gain, the LLC is most easily converted to another entity type (e.g. a C Corp) as circumstances change.
• Ease of Property Contribution: Because contributions to LLCs aren’t subject to the same tax complications for property contributions as S and C Corps, adding new owners in exchange for property contributions is much simpler with an LLC.
• Small Business Stock: When an LLC is converted into a C Corp, the new stock can still qualify as SBS if all the other requirements are met.
• Withdrawal of Borrowings: Owners of an LLC can include their share of the LLC’s borrowings in their tax bases in the in the interests of the LLC, even if they aren’t personally liable on the loans. This enables them to withdraw borrowing proceeds from the LLC on a tax-free basis and (subject to certain limitations) report greater loss.
• Tax Treatment: If an LLC makes a special tax election, people who acquire an interest by inheritance or purchase can write up their share of the LLC’s basis in its assets to their initial basis in their interest in the LLC, enabling them to report less income or greater deductions with regard to the assets. Note also: single member LLCs need not file separate tax returns from the sole member’s personal returns.

LLC Summary: Founders should consider an LLC if they want to avoid double taxation, while preserving the ability to issue interests to multiple classes or owners who do not qualify as S Corp shareholders. The LLC is the best choice as a short-term pass-through entity, and can be better suited for ventures investing in assets like real estate or securities, or that do not intend to utilize significant amounts of external capital for growth.

At-A-Glance:

As always, take any information on this site (and any firm’s website) as a jumping-off point for your research only, and seek advice tailored to your particular circumstances before taking any action that might affect your rights and best interests.  And, of course, we wouldn’t be good lawyers if we didn’t have our full range of disclaimers that apply to your use of this article, this blog, and this site generally.