By Joshua D. Freeman
Now that you have designed the experience and the exit of your business, you should be equipped with the priorities and understanding necessary to make a decision as to what kind of entity you should choose and how you want that entity to be taxed.
Growing up, we are taught to write we are reminded to mind our “p’s and q’s.” We are taught this so we don’t mix up things that happen to look alike. Similarly, just because a corporation and an LLC are both entities that offer some protection against personal liability to its owners, does not mean we should treat them the same. Remember that, like q and p, different entities should be used very differently—this is “puite imqortant” to understand. Then, as we start to consider taxation structuring to the entity, the distinction becomes more and more interesting.
In the following, our first task will be to understand the two different entity types that you need to choose. Once we understand that, we are going to complicate things and talk about how each entity type can be taxed.
The OG: Corporations
The original gangsta of liability protection for all owners is the corporation. Delaware adopted its corporation act in 1899 in a hope to attract more business to the state by allowing owners to avoid personal liability for the obligations and liabilities of the business. You see, prior to the corporation, the owners of businesses were personally on the hook for any debts and liabilities of the company. At time, when a business went under, the owners were bound to lose their savings, their homes, and their bank accounts. So when the corporation was introduced, business owners flocked. Delaware’s experiment succeeded and attracted a disproportionately large number of business filings to the state (we’ll discuss more about where to register your business later).
The downside of the corporation is in its taxation and required corporate formalities. Corporations are considered to be entities separate and apart from its owners. Because of this separation, the corporation statutes across the country require a certain structure, management and executed meetings.
The structure of a corporation is made of its shareholders (the owners), its board of directors (its big-picture managers), and its officers (its day-to-day managers). Each corporation must have each of these three parts and carry out annual meetings of the shareholders and board of directors. Corporations even have specific requirements for how to call these meetings and how to keep minutes and approve corporate actions.
Additionally, the IRS determined that corporations must be taxed separately and apart from the individual owners. This is what resulted in the oft-maligned double taxation for owners. At the time, business owners were forced to decide between the liability protection of a corporation with its double taxation and the more favorable tax treatment of a partnership but with no liability protection. This, the original corporation, is what is referred to as the C-Corp.
However, in the 1950s, in response to the double taxation problem, Congress instituted the small business tax election, creating the S-Corp. This election allowed a corporation with fewer than 100 owners, and whose owners were all individuals with United States residency, to be taxed similar to a partnership and not have to pay taxes at the corporation level. In addition to these limitations, the IRS implemented rules that to qualify to be an S-Corp, there can only be one class of financial stock. This one class of financial stock doesn’t allow for preferred shares and requires all owners be paid dividends, both operating and liquidating, on equal footing. Because of the limitations on company size, ownership structure, and stock financial preferences the S-Corp left much to be desired.
The New Kid on the Block: LLCs
In 1977, Wyoming (of all places) enacted the first limited liability company statute, which combined the liability protection advantages of a Corporation with the taxation and ownership flexibility of the partnership. Welcome, the new kid on the block; the ultimate business entity disrupter.
Initially, the IRS didn’t know what to do with limited liability companies (LLCs). At first, the IRS ruled that LLCs would be treated for tax purposes as corporations, but then in 1988, the IRS course corrected and ruled that the LLC could elect to be taxed as a partnership. Thus, resulting in an entity with the liability protection of a corporation, the tax and flexible business governance of a partnership, and the flexible capital structuring of both corporations and partnerships. To add even more flexibility, the IRS allows for an S-Election to be made for LLCs creating what I refer to as the S-LLC.
Since then, all 50 states have jumped on the LLC bandwagon to provide this flexible and beneficial entity type especially for small business and entrepreneurs. Now the LLC is the most widely used of all entity types and it is the exception and not the rule to use entity type other than an LLC when forming a business.
Pros and Cons of the Different Entity Types
Let’s now move our discussion into the detailed pros and cons of the multiple entity types. Because of the lack of liability protection offered by partnerships and sole proprietorship, I never suggest that they are used and thus I will not waste your precious time talking about them. Let’s take a look at are C-Corps, S-Corps, LLCs, and S-LLCs. Enjoy!
- Ultimate flexibility of capital structure
- Attractiveness to all types of investments, both VC and debt financing
- Double taxation
- No pass through losses for founders when operating in the red
- Corporate formalities required to maintain the liability protections
3. Ideal Candidate: High-growth startups wanting to attract top national VC firms or whose exit plan is through an IPO.
- Avoidance of double taxation
- Ability to lessen FICA taxes on owner-employees
- Extreme limitations in allowed capital structures
- All shareholders must be individuals with a few limited exceptions for grantor trusts
- There can only be one class of financial ownership interests, which means no preferred stock
- No foreign owners
- No more than 100 owners
- Many corporate formalities that need to be complied with to maintain the liability protections
3. Ideal Candidate: Small businesses with individual owners who don’t plan on raising Venture Capital or Private Equity financing or selling the business in near future. Commonly used for professional practices or family owned and managed business. Another common and sometimes necessary use of S-Corps is in real estate developer transactions. In these transactions, a landowner/developer can use an S-Corp to take advantage of the land's appreciation in value during its holding period prior to development. If this structuring is properly managed the owner may be allowed to lock in capital gains on the appreciation and bump up the basis of the land for the development gains which will be taxed as ordinary income.
LLC (Taxed as Partnership):
- Pass-through taxation
- Flexibility in capital structure
- Attractiveness to vast majority of potential investors and purchasers
- Flexibility in management
- Fewer entity formalities required for maintaining liability protections
- Disfavored by some VC investors, but with proper planning as discussed below, the adverse tax consequences can be mitigated
- Doesn’t have the ability to minimize FICA taxes to owner-employees as all income is passed through to its owners
- Owners can’t be employees of an LLC
3. Ideal Candidate: LLCs are the preferred entity because they are well suited for most all businesses unless inevitable VC financing is in your future or your planned exit is an IPO.
- All of the benefits of LLC listed above
- Ability to minimize FICA taxes
- All of the cons of S-Corps except the rigid corporate formalities are lessened
3. Ideal Candidate. Same as for S-Corps but these entities are a little more flexible in entity formalities and are thus generally more favorable than S-Corps.
Why VC’s Prefer C-Corps
The primary and best reason I have encountered in my experience as to why VCs prefer C-Corps is related to who their investors—or as their investors are regularly called their LPs—are. Because many large VCs have institutional and charitable entity investors, VCs have to be careful that the taxation structure of the startup being invested in doesn’t trigger any adverse affects for those investors.
Because LLCs have pass-through taxation, an institutional or charitable investor in a VC could have a taxable event of Unrelated Business Taxable Income (UBTI). Receiving UBTI could result in the institutional and charitable investors potentially losing their tax-exempt status. That would not be a good thing for a VC with those types of investors in its fund.
As to S-Corps and S-LLCs, because those entity types can only have common equity interests, VCs would not be able to invest in preferred stock. For that reason, VCs will almost always require S-Corps and S-LLCs to convert back to either a C-Corp or an LLC (if you have a more forward-thinking VC), which have much more flexible capital structures available to them.
Why Founders Should Stick to Their Guns and Insist on Staying an LLC
Just because some VCs can’t deal with pass-through income, and must live with double taxation, doesn’t necessarily mean that Founders have to as well. First, I’ll explain what double taxation means to a founder at exit, and then, I’ll explain a structure that can allow the VC to have the taxation protection of the C-Corp while also allowing the founders to continue to own their equity in an LLC.
Double Taxation Sucks. Double taxation could result in a significantly lower net exit for the founder. When you sell your business as we discussed earlier you can either do a stock or an asset deal depending on the status of your business and/or the market. If you can negotiate a stock deal, then you are golden either as a C-Corp or an LLC to avoid the liquidation double taxation trap, but if you get stuck in an asset sale then it could be a mess.
This example is oversimplified but illustrates the point. Assume you sell your business in an asset sale for $10,000,000. If you own that as an LLC after taxes at the highest individual tax rate (39.6%), you would walk with $6,140,000. Now assume you own the business as a C-Corp and are subject to double taxation, you would walk with only $4,912,000. That’s a difference of $1,228,000. I don’t know a lot of people who like to walk away from money like that.
What happens in the taxation of a C-Corp in an asset sale is that the $10,000,000 would first be taxed at the Corporate Tax rate of 20%, leaving only $8,000,000 to be distributed to the shareholders. Then the $8,000,000, that you would receive would then be taxed at you individual tax rate that would be 39.6%, leaving you only $4,912,000 of your hard-earned $10,000,000. The government is cool and all but not $1,228,000 cool.
Solving the UBTI Issue. Having an LLC converted to a C-Corp for a VC is only a major issue to VC’s that have institutional or charitable investors because, as discussed above, the UBTI could affect their tax-exempt status. However, we can solve this problem by creating a buffer corporation as the member of the LLC between it and the VC Fund. What this would look like is the business LLC would be owned by the Founders and the Buffer C-Corp, which would be owned by the VC Fund. So what effect does this have? The VC’s net exit will remain the same, but the Founder’s net exit will be significant larger.
I know this sounds very self-interested, but this is one of many good reasons why startups should hire good corporate counsel prior to negotiating with VC firms. Often what happens is the VC comes in and negotiates with the startup and introduces it to its legal counsel to document the deal for both parties, but legal counsel's allegiance and fiduciary duties ultimately lie with the VC. Because of that, VC’s legal counsel often fails to propose entity structures that maximize value for both parties.
1. Entity structuring is not a one-size fit all scenario and needs to take into account many factors including the type of business involved, its owners, and how it plans on raising money in the future.
2. LLCs are ultimately the best entity structure for founders unless you enjoy throwing large chunks of money at the government or are certain that an IPO is in the future.
3. Hire good corporate counsel early, and the few thousand dollars you spend on them could save you mountains of money at exit.