There are many good reasons, in making your choice of entity selection for a startup that desires to follow the traditional route of investment, hiring and growth to ultimate sale or IPO, to choose a C corporation rather than an S corporation or an LLC.
My top reasons for choosing a C corporation
- It is easier to form a C corporation than an S corporation or an LLC. (Simpler is not always but frequently better.) (For an example of what can go wrong with an S corporation election, see Rev. Proc. 2004-35.)
- You can issue qualified small business stock (“QSBS”) under Section 1202 of the Internal Revenue Code and potentially qualify for the exclusion from tax for QSBS and the rollover benefit under Section 1045 of the Internal Revenue Code. [For qualified small business stock acquired between the dates of September 27, 2010 and December 31, 2013, the tax rate after holding the stock for 5 years is ZERO--including a complete AMT exemption (subject to a cap (but a substantial one)).]
- You avoid having to issue your owners Forms K-1, subjecting them to federal income tax on the entity’s income (regardless of whether that income is distributed to them), and potentially subjecting them to state income taxes in the various states in which the entity has income tax nexus.
- You avoid having to agree to a cash distribution scheme to cover the taxes of the owners on the entity’s income taxed to them. This may make it easier to reinvest capital to grow the business.
- It is easier for a C corporation to engage in an equity or debt financing.
- Venture capitalists typically won’t invest in LLCs and can’t invest in S corporations.
- Only C corporations can go public (generally).
- Equity compensation in a C corporation is easier.
- C corporations can participate in tax-free reorganizations under the Internal Revenue Code. LLCs taxed as partnerships cannot. What this means is this–if you are operating as an LLC and are offered to be bought out by another company for stock, your receipt of that stock will be taxable to you–even if the stock is not salable and can’t be sold to generate cash to pay the tax. With corporations, it is possible to be bought out for stock on a tax-deferred basis, and not pay tax on the stock received until you sell it. This is an important exit strategy consideration.
- There are potential self employment tax savings over what would be possible with an LLC.
- There is no limit on the type or number of shareholders that you can have.
- The dreaded “double tax” that everyone is afraid of with C corporations rarely ever occurs (there are, of course, exceptions–the cash cow business being one). Most positive exits are 1 layer of tax events–either stock sales or mergers structured so that there is only 1 layer of tax–at the shareholder level.
- Although losses cannot be deducted by the shareholders of a C corporation, losses frequently cannot be deducted by non-active members of the company in any event–so the loss pass through benefit to passive investors is frequently in fact not very helpful.
- The actual tax benefit of the pass through of any losses may turn out to be substantially less than expected.
- The tax accounting complexities associated with maintaining capital accounts in accordance with the Treasury Regulations make LLCs expensive for companies that desire to raise multiple rounds of financing.
- LLCs may have to remit tax payments to the IRS on allocations to foreign owners. See IRC Code Section 1446.
“When X, an entity classified as a partnership for federal tax purposes, elects under § 301.7701-3(c)(1)(i) to be classified as an association for federal tax purposes, the following steps are deemed to occur: X contributes all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter X liquidates by distributing the stock of the association to its partners. Under § 301.7701-3(g)(3)(i), these deemed steps are treated as occurring immediately before the close of the day before the election is effective. Thus, the partnership’s taxable year ends on December 31, 2009, and the association’s first taxable year begins on January 1, 2010. Therefore, the partnership will not be deemed to own the stock of the association during any portion of the association’s first taxable year beginning January 1, 2010, and X is eligible to elect to be an S corporation effective January 1, 2010. Additionally, because the partnership’s taxable year ends immediately before the close of the day on December 31, 2009, and the association’s first taxable year begins at the start of the day on January 1, 2010, the deemed steps will not cause X to have an intervening short taxable year in which it was a C corporation.”
Rev. Rul. 2009-15.
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).
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