12 Reasons For A Startup Not To Be An LLC

Very seldom in our lives do we need to make 4,000 decisions in rapid succession. Welcome to the life of the owner of a startup. As decisions are made, founders often find themselves asking, “Can this seemingly mundane decision later profoundly affect the future growth and survival of my company?”

For the majority of the decisions, the answer would be “no,” particularly when one of the decisions is what you’re going to have for lunch in order to fuel you with the energy to make more decisions. However, there is one major decision that can set the tone, not only for founders and employees, but also those who will invest in the company: the type of entity you form.

What Are The Different Types of Business Entities?

I am approached all the time by owners of startups wondering whether to become a C Corporation, an S Corporation, or an LLC (a limited liability company).

What primarily differentiates these business entities from one another is their federal income tax characteristics:

C Corporation – A C Corporation is an entity that, in contrast to an S Corporation or an LLC taxed as a partnership, is subject to federal income tax and pays federal income taxes on its income.  Its shareholders are not subject to tax unless the corporation pays amounts to them in the form of dividends, distributions or salary.

S Corporation – An S Corporation is not subject to federal income tax. Instead the company’s shareholders pay federal income tax on the taxable income of the S Corporation’s business based on their pro rata stock ownership.

LLC – LLCs, like S Corporations, are “pass-through” entities, which means that their owners (referred to as members) pay the tax on the income of the LLC that is allocated to them based on the LLC agreement. For a sole member, unless an election is made to be taxed as a corporation, the LLC is treated as a “disregarded entity,” meaning that the sole member reports the LLC’s income or loss on his or her tax return just like a sole proprietorship, or division in the case of a corporate owner. For LLCs with multiple members, the LLC is treated as a partnership and must file the IRS Form 1065 (unless the entity elects to be taxed as a corporation). The members of the LLC are treated as partners for federal income tax purposes and each receives a Form K-1 reporting their share of the LLC’s income or loss for the members to report on their federal income tax return.

Why Shouldn’t I Choose To Form An LLC?

For tech or growth companies planning to follow the traditional path of regular and ongoing equity grants to employees, multiple rounds of financing, and reinvestment of as much capital into the business as possible, with the goal of an ultimate sale to a big, maybe public, company in exchange for cash and/or stock, LLCs are typically not the way to go.  There are a number of reasons.

1 – Many Investors Don’t Like LLCs - Investors frequently don’t want to complicate their personal tax situation by becoming a member in an entity taxed as a partnership. If you are an owner of an entity taxed as a partnership:

  • you will receive Forms K-1 from the entity, and
  • you will be taxed on the entity’s income even if no cash is distributed to you to pay the taxes.

2 – Many Investors Can’t Invest in LLCs - Some investors (such as venture funds), can’t invest in pass-through companies because they have tax-exempt partners which do not want to receive active trade or business income because of their tax-exempt status.

3- Reinvestment – LLCs taxed as partnerships will typically have provisions in their LLC agreements detailing how and when cash will be distributed to the owners to cover the taxes that they will owe on the entity’s income. This can complicate the ability of the entity to reinvest its cash to grow the business.

4 – Potential Taxation in Other States - If the business has an active trade or business and does business in other states, passive investors may become subject to income tax in those other states.

For example: if you are a partner in a partnership which does business in CA, even if you live in WA and are a passive investor, you will receive a California Form K-1 and have to file California income tax returns and pay California income tax.

This can really turn investors off.

A similar thing happens when non-US persons invest in US LLCs.

5 – Many Investors Prefer the Simplicity of Owning Stock in a C Corp - Investors in early stage businesses usually just want to make an investment, acquire a capital asset (the 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.

6 – Equity Compensation - Equity compensation in entities taxed as partnerships is much more difficult, complex and expensive to draft and administer than equity compensation in a C or S Corporation.  For example, to grant profits interests in an LLC, it is typically necessary or advisable to “book up” the capital accounts of the owners prior to granting the profits interests, and this must happen at each award. If there are successive rounds of equity grants each year, these books-ups can become very expensive and time consuming.  This same complication occurs with options or warrants to acquire LLC interests.

7 – Raising Capital - Raising additional capital through an LLC is much more difficult than raising a next round through a corporation. LLC agreements are more difficult and complex to prepare than their corporate counterparts. In addition, you can hit upon sticky and highly complex tax issues in the LLC context that just don’t exist or arise in the corporate context.

For example: You give your investors a 2x liquidation preference. If you are an LLC, your investors may have a tax hit in the year of investment! This does not happen in the corporate context.

8 – Stock Swaps - LLCs cannot engage in tax deferred stock swaps in acquisition scenarios, which corporations can.

For example, your startup is acquired by BigCo, for $400M in stock. The stock is subject to a 1 year lockup before it can be sold in the public markets. You will owe tax on the stock upon closing, regardless of the lockup. If you were a corporation, you could probably exchange your startup stock for BigCo stock on a tax deferred basis under one of the reorganization provisions under Section 368 of the Internal Revenue Code.

9 – Documents - LLC agreements are much more complex and difficult to draft than corporate documents.

10 – Familiarity - Investors are less familiar with LLCs than corporations, and so they typically have to spend more time on diligence reviewing the underlying documents before deciding whether or not to invest.

11 – Contract Creatures - LLCs are more “contract” creatures than “statutory” creatures. Meaning, although there are default rules set forth in the LLC statute, in an LLC the general rule is that most anything goes—so whatever you put in your contract  will usually govern—as a result, the contracts are longer and more difficult to put together and take more time to be reviewed, negotiated, agreed upon, etc.

12 – Section 1202 – The Section 1202 reduction in capital gains tax and Section 1045 rollover benefits for “qualified small business stock” are not available for LLC interests. (Sadly, the 100% exclusion from tax for QSB stock held for 5 or more years expired at the end of 2013. Tell your Congressional representatives to renew it!)

The Bogeyman Rarely Comes Out of the Closet

The bogeyman that you will hear about most frequently is the “double tax” bogeyman. You will be told—don’t form a C Corporation because you will be subject to a double tax.

What is meant by this is that if the C Corporation makes money, it will pay tax on that money. And if it pays dividends to its shareholders, they will pay tax on the dividends. This is true. And so if you anticipate your business being a cash cow, and immediately generating so much money that you will earn more than you can reasonably pay out in salary to the owner executives, then maybe an LLC is a good choice for you. But for most growth businesses, whose goal is to raise capital, reinvest capital, grow fast, grant equity incentives, and ultimately be acquired or go public, a C Corporation is the way to go.  For these businesses, the double tax bogeyman rarely appears, and most exits are structured as one layer of tax stock sales.

Why Not Start as an S Corporation?

If an LLC is not so great, but you desire pass through tax treatment, an S Corporation could be a great choice for you if you qualify.  Keep in mind though that if you are a founder you will forego the potential 1202 reduction in capital gains tax rate and Section 1045 rollover benefits for your founder shares if you form as an S Corporation.

Lipstick on an LLC

I generally advise my startup clients to go with a C Corporation because it’s easier. Investors can be finicky and any sort of obstruction or tax inconvenience can turn a hot investor very cold very quickly. Of all of the decisions you will make in starting your business, perhaps none will affect you more tomorrow than your choice of entity.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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  • Ed Rodriguez

    Hi Joe, Many thanks for continuing to publish one of the best legal blogs for start-ups, and also for providing one of your avid readers (me) with valuable opinions this past summer on the issue of LLC vs. S/C Corporation. Warren Buffet said that the most expensive error he ever made was not to re-incorporate a second company rather than rolling up Berkshire into the Hathaway shirt business investment. It is clear that this is a key decision that even the smartest entrepreneurs don’t diligence sufficiently. As I mentioned, it appears that the LLC is being used as a best path for initiating small projects to be R&D’d into potential future companies each with their own funding strategy. One alternative that I have not seen covered in much detail is the option to form an LLC, but then to elect the LLC to be taxed as an S Corp.  Apparently, this would both eliminate the C Corp administrative hassles, and also allow the owner to bypass the 15% self-employment income tax on all earnings in favor of tax on some reasonable founder’s salary with an allocation of dividend. As with all incorporation options, no doubt there are pros and cons to this alternative given the entrepreneur’s situation and vision for his company.   A blog like yours that covers both the short and long-term taxation and legal aspects of these decisions provides differentiated value to start-ups. Thanks again, Joe!

    • Joe Wallin

      Thanks Ed. I am not sure if forming an LLC, then electing to be taxed as a corporation, and then making an S election, is any better than just forming a regular state law corporation and then making an S election. Whether you form a state law LLC or a state law corporation, you should still keep minutes, and keep up with other corporate formalities. I don’t think you escape these things because you have chosen the LLC form. In any event, I appreciate your thoughtful comment!

  • Mmezeus

    In the case of an S corporation, is the funds used to start up the corporation taxable?  for example if I deposits $50,000 into the corporate account to start my new business, will I have to pay taxes on the 59k at the end of the year?

    • http://startuplawblog.com/joewallin Joe Wallin

      The answer should be no, but you should consult with your tax advisor as to the specific facts of your situation to confirm. Don’t rely on a reply to a blog comment!

      • Omryszuk

        Joe, I have an LLC now which will be providing services to suppliers with ONLY part time employees until the business grows. It seems that the LLC is the proper way to go for such a business. However, I’m also developing a software which the LLC will use, but to get there, I’ll need to give shares for development, and after proof of concept, have them available for investors. The goal is to sell the software to existing companies and then sell within 4-6 years for substantial earning. Would it be best to go the C-Corp route here?

        • http://startuplawblog.com/joewallin Joe Wallin

          I would be happy to talk to you about this on the phone. 206 757 8184

          • Omryszuk

            Let me know the most convenient time for you. Thanks

          • robbyoconnor

            A group myself and 2 friends are thinking of establishing an LLC…question is, is an LLC a mistake…if we later need investors can we re-incorporate when and if an investor wants shares? Our company could organically grow but having the option to offer shares is also valuable…what should we do?

          • http://startuplawblog.com/joewallin Joe Wallin

            Well, it is one of those classic dilemmas. I would be happy to talk to you about this on the phone. 206 757 8184

          • robbyoconnor

            Will probably contact you soonish…we chose to hold off on establishing the corporation until we have a viable product

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  • Roy Berg

    Great article Joe.

    Another reason to avoid LLCs is from the international perspective.
    1) Hybrid vehicles (including LLCs, LLPs, LLLPs, etc.) typically do not get treaty benefits under either the OECD or US Model Treaty. See, for example IV(6),(7) of the US/Canada treaty. This can result in a significantly higher tax burden both on income and gains.
    2) Hybrid vehicles are often taxed differently in foreign jurisdictions. In Canada, for example, LLCs are taxed as corporations.
    The combination of the loss of treaty benefits and disparate foreign/domestic tax treatment can result in double and even triple taxation.

    • http://startuplawblog.com/joewallin Joe Wallin

      Thank you Roy. Great points!

  • Bill

    Joe, good post but I am surprised that you do not address the two big tax advantages of an LLC. The single layer of tax on profits (individual tax only rather than corporate tax followed by individual tax) is the key driver for many. If you take a startup that is successful and profitable but not a billion dollar technology company, you may really kick yourself for not having gone the LLC route. There are a lot of startups where LLCs end up a better choice, particularly if you are bootstrapping or if you are in a business that does a lot of professional services (which can be profitable but rarely yield huge exit sale prices).

    Second, you mention the lack of stock for stock swap deals. But you fail to mention the ability of a buyer to step-up its basis in the assets (not available in most C-Corp deals unless you are doing a spin-out from a larger company qualifying for 338(h)(10)). The basis step-up has a massive benefit to a buyer from a tax perspective and real economic benefit to sellers. Typically the value of that step-up is modelled separately and is added to bhe purchase price. The value increase can be very significant if your buyer is a profitable company.
    Agree on all the other points and the complexity is very real, but worth noting the advantages quickly and that someone cannot go backwards from C-Corp to LLC as a general matter.

    • http://startuplawblog.com/joewallin Joe Wallin

      Good points Bill. in my experience, the double tax never happens, and most companies I work with want to raise money from third parties and regularly grant stock options. In these cases, in my opinion, LLCs are a bad fit.

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  • Eric Krebs

    I have recently seen an 83(b) election on the certificates of membership on a Delaware LLC taxed as a C-corp. But, the blog is great.

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  • Mike

    Joe
    I recently formed a LLC for my company that does windshield repairs. I have one investor at 20%. I will be adding contract employees as I grow. What are our tax issues and how should we file?

    • http://www.joewallin.com Joe Wallin

      Mike, do you have a tax accountant? Do you have a lawyer?

      • Mike

        I do have an accountant

      • Kim

        Hi,
        I am operating a salon which I formed as an LLC and S Corp. Can I dissolve the LLC since I made the mistake of forming the LLC or is it too late? I want to plan for a sale and sell shares. Thanks for sharing.
        Kim

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  • Deborah

    I’m in an LLC and for the last 2 years I can not seem to follow the money, when it comes
    to a profit balance that is being left in my share ( after distributions and out of state taxes)..
    We are paying down more debt ( principal) in the business but shouldn’t I be able to
    clearly follow the money when it comes to a 30 percent chunk of my profit share going
    to debt? I have inquired about this with other member .. still unclear how this is being
    accounted for.

  • http://krebslawfirm.com eric k

    After reading the 12 reasons not to have an LLC, you may have not address some factors:
    1. Even if you have an LLC, many states will let you convert to a Corporation with little problem;
    2. Many states limit remedies to disputes with LLCs to charging orders meaning that creditors cannot become equity owners;
    3. Some investors may actually prefer a Delaware LLC over a local state corporation;
    4. LLCs owned by husband and wife in community property states may be beneficial for estate tax planning over corporations;
    5. Real estate ownership is better in LLCs not taxes as C or S corporations; and,
    6. Many large corporations are converting from corporations to LLCs, why?

    In other words, one size does not fit all businesses.

    But, you blog does make a persons think about the best entity for the individual business.

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  • frank free

    can a LLC taxed as Sub C Corp have 3 owners who receive distribution after one of the others is paid a salary.

  • http://lawofficeleadstoday.com John Carter

    One other issue is that some companies won’t take your contract unless you’re a C Corp. I had to this to do consulting for a power company in the UK. Great post! Thanks for sharing and happy holidays!