Potential Advantages of Forming as an LLC

30 December 2014 Innovative Technology Insights Blog

One of the initial decisions for entrepreneurs is whether to form their new entity as a limited liability company (LLC) or a Corporation. Entrepreneurs are often told by advisors that angel investors and VCs will only invest in Delaware C-corps. So if you want to raise money, the choice is simple – choose Delaware C-corp. And if you choose this well-traveled path, you won’t be alone – most venture backed companies are Delaware corps. But that should not preclude consideration of an LLC as the entity of choice for many reasons.  

First, LLCs provide flow through tax treatment, meaning that profits are taxed at the shareholder (member) level only. This is in contrast to profitable C-corporations that pay a corporate tax (at the entity level) and then a second tax at the shareholder level when distributions are made to shareholders. So if it turns out that your investors do not require you to be a C-corp after all, and you are profitable, you (and your investors) will be paying far less in taxes if you chose an LLC over C-corp.

As a middle ground option, entrepreneurs can select a corporate structure and then file an election to have the corporation treated as an S-corp instead of a C-corp. S-corps are treated like partnerships for tax purposes (but C-corps for all other purposes) resulting in the flow through tax treatment discussed above. However, an S-corp needs to meet numerous hurdles to achieve and maintain its tax status — all shareholders must be U.S. citizens or residents and must be individuals (not entities) with certain limited exceptions, and the corporation can have no more than 100 shareholders, to name a few.

Second, LLCs can provide more attractive equity grants to executives. Executives who are being recruited to join companies often ask for equity grants that provide them capital gains tax treatment without requiring an initial capital expenditure by the executive. Corporations can offer a stock restriction arrangement that provides capital gains tax treatment but requires the executive to buy the stock at the onset, or an incentive stock option that can provide capital gains tax treatment but requires the executive to exercise the option and hold the stock for a full year – neither is ideal from the executive’s perspective if the company does not have a positive exit event. On the other hand, LLCs allow the company to grant a “profits interest” to executives. Simply put – this is an equity grant to the executive that the executive does not pay for – instead, the grant contains a built in “hurdle” equal to the value of the equity at the time of grant. When the company is sold, the executive receives payment on the shares to the extent the value of the shares exceed the hurdle value. And the gain to the executive is treated as capital gains (not ordinary income).

The above highlights a few of the important differences between corporations and LLCs.  In light of the various advantages that LLCs offer over corporations, entrepreneurs are advised to seriously consider the benefits of the LLC in light of their own specific situation when choosing their new entity. They are also advised to talk to their investors and management team as they will be the real beneficiaries of this decision. Lastly, we recommend consulting with an accountant or tax advisor during the decision-making process.

This blog is made available by Foley & Lardner LLP (“Foley” or “the Firm”) for informational purposes only. It is not meant to convey the Firm’s legal position on behalf of any client, nor is it intended to convey specific legal advice. Any opinions expressed in this article do not necessarily reflect the views of Foley & Lardner LLP, its partners, or its clients. Accordingly, do not act upon this information without seeking counsel from a licensed attorney. This blog is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Communicating with Foley through this website by email, blog post, or otherwise, does not create an attorney-client relationship for any legal matter. Therefore, any communication or material you transmit to Foley through this blog, whether by email, blog post or any other manner, will not be treated as confidential or proprietary. The information on this blog is published “AS IS” and is not guaranteed to be complete, accurate, and or up-to-date. Foley makes no representations or warranties of any kind, express or implied, as to the operation or content of the site. Foley expressly disclaims all other guarantees, warranties, conditions and representations of any kind, either express or implied, whether arising under any statute, law, commercial use or otherwise, including implied warranties of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Foley or any of its partners, officers, employees, agents or affiliates be liable, directly or indirectly, under any theory of law (contract, tort, negligence or otherwise), to you or anyone else, for any claims, losses or damages, direct, indirect special, incidental, punitive or consequential, resulting from or occasioned by the creation, use of or reliance on this site (including information and other content) or any third party websites or the information, resources or material accessed through any such websites. In some jurisdictions, the contents of this blog may be considered Attorney Advertising. If applicable, please note that prior results do not guarantee a similar outcome. Photographs are for dramatization purposes only and may include models. Likenesses do not necessarily imply current client, partnership or employee status.