I typically prefer C corporations as a choice of entity for early stage technology companies. However, occasionally a pass through entity is the right choice of entity, especially when the founders will fund the initial losses and want to deduct those losses on their individual tax returns (i.e., pass through income tax treatment) (and the founders do not mind passing on the potential tax exclusion for capital gains under Section 1202 of the Internal Revenue Code–which is only available for C corporation stock). Which raises the question, what is the better choice of entity today for a startup company whose founders are going to be actively involved, fund early losses, and want the ability to deduct those losses on their personal income tax returns—an LLC (for this purpose, one assumed to have multiple members and taxed for federal income tax purposes as a partnership) or an S corporation? (Mind you, a flow through entity choice will cost the founders the qualified small business tax benefit of IRC Section 1202 and the rollover benefit of IRC Section 1045.)
The answer depends on a number of factors, including whether the founders want to specially allocate the early losses among themselves (meaning, share them other than in proportion to stock ownership). Special allocations aren’t allowed with an S corporation. But if there is no desire to specially allocate losses, I believe the S corporation is the better choice—assuming the entity meets the criteria for making an S election. Why?
- S corporations can participate in tax-free reorganizations — S corporations, just like C corporations, can participate in tax-free reorganizations (such as a stock swap) under IRC Section 368. LLCs with multiple members taxed as partnerships cannot participate in a tax-free reorganization under IRC Section 368. This is a significant reason not to choose the LLC format if a stock swap is an anticipated exit strategy. The last thing a founder wants to discover on a proposed all stock acquisition is that the stock received will be taxed, even though non-liquid.
- S corporations can grant traditional equity compensation awards — S corporations can adopt traditional stock option plans. It is very complex for LLCs to issue the equivalent of stock options to their employees, and although they can more easily issue the equivalent of cheap stock through the issuance of “profits interests,” the tax accounting for a broadly distributed equity incentive plan in an LLC can be very complex and costly.
- S Corporations Can More Easily Convert to C Corporations — It is typically easier for an S corporation to convert to a C corporation than it is for an LLC to convert to a C corporation. For example, upon accepting venture capital funding from a venture fund, an S corporation will automatically convert to a C corporation. For an LLC to convert to a C corporation, it is necessary to form a new corporate entity to either accept the assets of the LLC in an asset assignment or into which to merge the LLC. Also, converting an LLC to a C corporation may raise issues relating to conversions of capital accounts into proportionate stockholdings in the new corporation that are not easily answerable under the LLC’s governing documents.
- There May Be Employment Tax Savings Associated With An S Corporation — An S corporation structure may result in the reduction in the overall employment tax burden. LLC members are generally subject to self-employment tax on their entire distributive share of the LLC’s ordinary trade or business income, where S corporation shareholders are only subject to employment tax on reasonable salary amounts and not dividends.
- Sales of Equity and Initial Public Offerings — S corporations can more easily engage in equity sales (subject to the one class of stock and no entity shareholder (generally) restrictions) than LLCs. For example, because an S corporation can only have one class of stock, it must sell common stock in any financing (and this makes any offering simpler and less complex). An LLC will often have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity (although its S corporation status will have to be terminated prior to such an event). As a practical matter, an LLC will need to transfer its assets to a new corporation or merge with a new corporation before entering the public equity markets because investors are more comfortable with a “typical” corporate structure.
- Simplicity of Structure — S corporations have a more easily understandable and simpler corporate structure than LLCs. S corporations can only have one class of stock — common stock — and their governing documents, articles and bylaws, are more familiar to most people in the business community than LLC operating agreements (which are complex and cumbersome and rarely completely understood).
The upsides of an LLC as opposed to an S corporation?
- Flexibility of Ownership — LLCs are not limited with respect to ownership participation. There is no limit on the number of members an LLC may have. S corporations, in contrast, can only have a limited number of shareholders. Similarly, LLCs may have foreign members (although upon becoming a member of an LLC, a foreign member may suddenly become subject to the U.S. tax laws and have to file a U.S. tax return filing; additionally, an LLC will have to withhold on allocations of certain types of income to foreign members); S corporations cannot have foreign shareholders (all shareholders must be U.S residents or citizens). As a practical matter, an LLC may not a viable choice of entity for an entity that will have foreign investors or investors that are themselves pass-through entities with tax exempt partners, because such investors may refuse or not be able to be members of an LLC.
- Special Allocations of Tax Attributes — An LLC has the flexibility to allocate tax attributes in ways other than pro rata based on stock ownership. An S corporation’s tax attributes must be allocated to shareholders based on the number of shares they own.
- Debt in Basis — An LLC member’s basis for purposes of deducting pass-through losses includes the member’s share of the entity’s indebtedness. This is not the case with S corporations.
- More Certainty in Tax Status — S corporations must meet certain criteria to elect S corporation status; they must then make an election; they must then not “bust” that status by violating one of the eligibility criteria. LLCs generally do not have to worry about qualifying or continuing to qualify for pass-through treatment.
- Tax-Free Distributions of Appreciated Property — An LLC can distribute appreciated property (e.g., real estate or stock) to its members without gain recognition to the LLC or its members, facilitating spin-off transactions. An S corporation’s distribution of appreciated property to its shareholders results in the recognition of gain by the S corporation on the appreciation, which gain then flows or passes through to the S corporation’s shareholders.
- Profits Interests — It is possible to grant “cheap” equity to service providers through the use of “profits interests” under Rev. Proc. 93-27. See also Rev. Proc. 2001-43. It is more considerably more difficult for S corporations to issue cheap equity without adverse tax consequences to the recipients.
- Payments to Retiring Partners — Payments to retiring partners may be deductible by the partnership; payments in redemption of S corporation stock are generally not deductible.
- Ease of Tax-Free Formation — Appreciated property can be contributed tax-free to LLCs under one of the most liberal nonrecognition provisions in the IRC. Contributions of appreciated property to S corporations in exchange for stock must comply with more restrictive provisions of the IRC to be tax-free (i.e., IRC Section 351) (although this is not usually a problem).