Choice of Entity: LLC vs. Corporation
Introduction to Business Entities for Entrepreneurs
For many entrepreneurs, their first experience with corporate law occurs when they decide to organize their fledgling business into one of the several forms of business entities permitted by law in most states. For the first-time business owner, the options presented by legal counsel can be confusing, in part because the differences among some types of business entities are subtle or highly technical. The appropriate form of entity can depend on numerous factors, including the nature of the business, its intended ownership and management structures, the need to raise equity capital, the desired tax treatment of income and losses and the importance of limiting the personal liability of the business’s owners. The good news is that for nearly all startup businesses (particularly the tech, tech-enabled or life science businesses that I most commonly represent) the choice of entity can be narrowed down to two options – the corporation or the limited liability company.
Advantages of Corporations and LLCs
Corporations and limited liability companies (generally referred to as “LLCs”) offer two major advantages relative to other forms of business entity.
Protection from Liabilities
First, corporations and LLCs afford their owners maximum protection from the liabilities incurred by the business. In most circumstances, the liability of the owners of a corporation or LLC (shareholders or stockholders for a corporation and members for an LLC) is capped at the value of their investment in the company, meaning that, other than the amount invested, the personal wealth of the owners is not at risk, even if the business goes belly-up. This protection against personal liability is critical. Unless and until an entity is formed, in the eyes of the law, the founder and the business are one and the same. Without an entity in place, the founder’s personal assets are at risk. Operating through an entity provides liability protection and ensures that the value being built is within the walls of the company.
Second, with a corporation or LLC, it is possible – subject to satisfying certain conditions – to choose whether the income of the business will be attributed directly to the owners, and therefore taxed at each owner’s applicable individual tax rate, or taxable to the company. Before forming your company, you should discuss with your tax adviser which tax treatment is most advantageous for you and your business.
Benefits and Drawbacks of LLCs
There are certain benefits of the LLC structure. For one, LLCs offer the benefit of what is known as “pass-through” taxation. That means, the company is not taxed, but rather the members who own the company pay the taxes or enjoy the benefit of tax losses. Remember, we are talking about start-up companies here. These companies very often don’t generate revenue immediately and are likely to incur early losses. This tax pass-through status allows the members of the company to offset other forms of income.
One downside of an LLC is that institutional investors, such as venture capitalists, do not want to invest in this tax pass-through entity. They will likely require that the LLC be converted into a corporation as a condition precedent to their investment.
Another downside of LLCs is that they are not qualified small business stock (QSBS) eligible. There will be more on this below.
The Appeal of C Corporations
Forming a corporation is often the better choice. In another article, we will break down the difference between “C corporations” and “S corporations.” For purposes of this article, I am going to focus C corporations.
Investor Expectations and QSBS Eligibility
There are a number of benefits to being a C corporation. For one, as noted above, institutional investors prefer and expect it.
A second benefit is the QSBS eligibility that I teased earlier. QSBS provides a potentially significant tax benefit to the holders of stock of a qualified small business (up to a 100% exclusion of tax on capital gains). I am going to over-simplify here but understand that the rules are extremely technical and must be reviewed carefully on a case-by-case basis. Some of the key requirements are: (i) the company must be a C corporation (so the time holding an LLC interest won’t count); (ii) the stockholder must hold their stock for a holding period of at least 5 years; (iii) the company must have had less than $50M in gross assets (not valuation) at all times before and immediately after the equity was issued, and (iv) the company’s business must not be on the IRS’s list of excluded businesses). If you meet the QSBS eligibility requirements, upon sale of your stock, your gain will be up to 100% federal tax free for the first $10M per stockholder or 10 times your cost-basis in the stock.
A few important notes on QSBS:
– It is only available for investments in corporations – if a company is formed as an LLC and converts to a corporation later, the time spent holding the LLC interest does not count toward the 5-year holding period.
– It is only available to holders of stock. QSBS is, therefore, not available to securities that are convertible into stock (such as stock options or warrants) until such convertible securities are actually converted into stock (common or preferred).
Equity Incentives for Employees
The last benefit of forming a corporation that I will discuss in this article relates to the grant of certain equity incentive. Simply put, employees of corporations can receive stock option awards that have favorable tax treatment to the recipient. These are known as Incentive Stock Options. They are only available to employees of corporations. This matters for many tech, tech-enabled and life science companies because they often rely on stock options as an important element of the compensation they pay to employees.
Making the Right Choice for Your Business
No matter what type of business you are starting you need to consider your specific circumstances before choosing the best form of business entity for your business.
The discussion may not cover all of the factors relevant to your decision, so you should consult a lawyer if you have any questions.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.