Friday, October 19, 2012

Startups: Choosing between an LLC and a Corporation

The first question that startup founders often ask a lawyer is "what is the right type of entity for my company." If you Google the subject, which you have probably already done bringing you here, you will see that there are a plethora of opinions. Most advice will be split into two campus: arguing in favor of either a corporation or a limited liability company (an LLC).

Almost everyone knows the core difference between a C-corporation and an LLC from a tax perspective -- LLCs get pass-through treatment (unless otherwise elected), such that all gains and losses of the LLC are recognized on the US tax returns of its owners (known as members). By contrast, C-corporations are treated as separate legal entities for tax purposes. Owners in corporations (known as shareholders) are not taxed on the corporation's gains and losses, though they are taxed individually if they receive a distribution (e.g., a dividend).

Very likely, you are reading this and thinking, "Yes, I know, but so what? I still don't know whether to form a corporation or an LLC." So let's see what this means for us.

I would posit that if you are a true startup (not a small business), the following will be very important to you: (a) being cost-efficient, and (b) obtaining funding from investors. If you agree with the premise and find yourself in that boat, read on.

Investors. Institutional investors (funds) will almost always require a company in which they are investing to be a C-corporation. There are several reasons for this:

  • Administrative Burden. Investment funds are generally pass-through entities themselves, so their limited partners would be burdened with K-1 forms (the tax form which is issued to members in an LLC which allocates LLC's gains or losses to such member) for each investment by each investment fund in which such limited partner is participating.

  • Tax Exempt Status. Some investment funds can't invest in LLCs because of their tax-exempt status or the tax exempt status of their limited partners.

  • U.S. Tax Obligations for Foreign Funds. LLCs create a problem for foreign investors who may not otherwise be subject to US taxation or to US tax filing requirements.

  • Structure. Investors like corporations because of the rigid time-tested structure that they provide. Corporations are owned by shareholders who vote for and elect a board of directors. The board of directors votes on important company decisions and, in turn, elects officers, who run the corporation day-to-day. The shareholders (among them the investors) have clear rights, among them, to remove the existing board and elect a new slate of directors if they feel that the corporation is getting derailed. LLCs are known for being more flexible. Rigidity can be built into them, at an extra cost, but is not inherent to this entity form.

Efficiency. In an LLC, the entirety of the understandings between the members as well as the ownership, management, and tax structures, are contained in a single agreement - the limited liability company operating agreement. This is a complex, difficult to understand, tax-heavy document, which requires much customization and deep tax expertise. This translates into many attorney hours and expensive tax counsel. On the other hand, corporate formation and financing use several smaller agreements, forms of which have become largely standardized over the years such that these agreements are actually faster and simpler to draft than the LLC operating agreement. Each corporate document has a narrow purpose, and because the corporation is a stand-alone legal entity, tax analysis for the members does not come in like it does in the LLC operating agreement. Faster, simpler, and no tax review all spell "cost-efficient".

Conclusion. For a typical startup that plans on raising capital, I think it's not worth spending a lot of time debating the pros and cons of different entity types. Bottom line is, forming a corporation will save you a lot of unpleasant discussions with investors down the road and, ultimately, the cost of converting your LLC to a corporation.

It goes without saying that there are exceptions to every rule. For instance, the founders may plan to bootstrap for several years and the LLC form would allow them to write-off operating losses during those years against their ordinary income from other sources. Or, a startup's capital may come from an angel investor who really likes the pass-through losses that he can take through his investment in an LLC. Or, friends and family investors may be providing capital with the idea of getting regular dividends, without double-taxation eating into the profits.

The above scenarios, however, are not typical startup issues, which is why typically, the right choice is to incorporate. But if you are in doubt or there is something unusual about your situation, you should consult a tax and/or legal advisor.

Happy company making!

Inna


White Summers  Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.
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