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.