Choice of Entity: LLC vs. C Corporation

LLC vs. C Corporation

Are you considering what type of entity to form for your new venture?

Suppose you have narrowed it down to either a C corporation or a limited liability company (LLC) taxed as a partnership. Perhaps you aren’t considering an S corporation because you either don’t qualify or you don’t want to give up the chance to incorporate and still take advantage of the qualified small business stock exemption later – which you can do if you start out as an LLC taxed as a partnership, but not if you start out as an S corporation (more on this below.)

So, in this situation, which entity should you choose: an LLC taxed as a partnership or a C corporation?

Choosing whether a C corporation or an LLC is the best choice of entity for your stakeholders and the business involves asking yourself a number of different questions. These include:

    • Will you or do you plan to raise equity capital from angel investors or venture funds?
    • Will you or do you plan to to grant equity incentive awards to service providers?
    • Do you want to follow the traditional path of trying to build a business to sell it?
    • Do you want to build the business to operate it to share the profits with the owners on a regular and ongoing basis, with no pressure to sell it to get liquidity for your investors and stock option holders?
    • What do you think the most likely exit for the company will be, based on what you know now?

LLC vs. C Corporation

If you want to follow the traditional path of raising capital, issuing compensatory equity incentive awards, and growing the business as fast you can to reach an exit, then starting out as a C corporation (typically in Delaware) probably makes the most sense. The benefits of taking this traditional path are amplified in a dramatic way by the $10 million exclusion from tax for qualified small business stock held for at least 5 years, which is a benefit only applicable to C corporations and not available to LLCs.

However, if you don’t necessarily want to build a business to sell it, and you don’t want to feel the pressure from investors or your option holders to create liquidity for them, LLCs offer an interesting alternative. With an LLC, because there is only one layer of tax, it is easier to distribute cash on an ongoing basis than with a C corporation. This isn’t as easy to accomplish in the corporation format, because C corporations pay taxes, and then their shareholders pay taxes again when the cash is distributed.

Below is a pros cons analysis of these two different types of entities with respect to the most commonly considered issues.

LLC Advantages; C Corporation Disadvantages

Limited Liability Company LLC

Single Level of Tax

LLCs are pass-through entities: their income is subject to only one level of tax, at the member level (up to 37 percent plus state income tax if applicable). A C corporation’s income is subject to tax (at a rate of 21 percent), and any “dividend” distributions of earnings and profits to shareholders that have already been taxed at the C corporation level are also taxable to the shareholders (at a rate of as high as 23.8 percent) (i.e., the income can be taxed twice). Thus, because LLCs are pass-through entities and the income from the business is only taxed once, you would expect them typically to be more tax efficient than C corporations.

Sale of Assets

Buyers of businesses prefer, if possible, to get a basis step up in the assets of the business being acquired. This is possible with an LLC and not possible with a C corporation without triggering a second layer of tax. This is probably the biggest complaint or concern with C corporations.

Pass-Through of Losses

Generally, losses, deductions, credits, and other tax benefit items pass through to an LLC’s members and may offset other income on their individual tax returns (subject to passive activity loss limitation rules, at risk limitation rules, basis limitation rules, and other potential limitations). A C corporation’s losses do not pass through to its shareholders.

Tax Free Distributions of Appreciated Property

An LLC can distribute appreciated property to its members without gain recognition to the LLC or its members, facilitating spin-off transactions. A C corporation’s distribution of appreciated property to its shareholders is subject to tax at the corporate level and possibly tax at the shareholder level as well.

Basis Step Up

Members receive a basis step-up in their LLC interests for income left in the LLC and not distributed. Because there is no pass through of income in C corporations, this is not true in C corporations.

Tax Free Formation

Appreciated property can generally be contributed to LLCs tax free under one of the broadest nonrecognition provisions in the IRC (IRC Section 721). Tax free capitalizations for C corporations must comply with the more restrictive provisions of the IRS to be tax free (i.e., IRC Section 351), although this is not usually a problem.

C Corporation Advantages; LLC Disadvantages

C Corporation

Qualified Small Business Stock Benefits

C corporations can issue “qualified small business stock.” LLCs cannot issue qualified small business stock. Neither can S corporations.

What are the benefits of “qualified small business stock?” If you acquired the stock after September 27, 2010, and you hold it for 5 years, you can exclude up to $10 million entirely from federal income tax, including the alternative minimum tax. If you haven’t met the 5 year holding period, there is a rollover possibility under Section 1045. The Section 1202 QSBS benefit is dramatic. If you qualify for it, it might literally save you $2.38MM in federal income tax on the sale of your company. To issue qualified small stock, a C corporation has to meet a number of requirements, but the QSBS benefit is widely available.

Traditional Angel and Venture Capital Investments Can Be Made

The issuance of convertible preferred stock by C corporations is the typical vehicle for angel and venture capital investments. One of the problems with LLCs is their flexibility. Under most LLC statutes, the members can essentially agree on whatever they want to in their LLC Agreement — sometimes even waiving fiduciary duties. This means every LLC Agreement has to be carefully reviewed before making any investment. Some investors just don’t like LLCs. Foreign persons who invest in LLCs may suddenly have to file US tax returns. C corporations do not present these difficulties.

Traditional Equity Compensation is Available

C corporations can issue traditional stock options and “incentive stock options.” It is much more complex for LLCs to issue the equivalent of stock options to their employees. LLC equity grant awards typically take the form of profits interest, but this requires complex capital account maintenance work which you do not encounter in the C corporation context. “Incentive Stock Options” also are not available to LLCs.

Ability to Participate in Tax-Free Reorganizations

C corporations can participate in tax free reorganizations under IRC Section 368. LLCs cannot participate in tax-free reorganizations under IRC Section 368. What this means as a practical matter is that if you form as an LLC and a company wants to acquire your company in exchange for stock in the acquiror company, the transaction will be taxable — even if there is no cash in the deal. With a corporation, if structured properly, an acquisition of your company for stock of the acquiror can be a tax free deal.

Self-Employment Taxes

C corporation shareholders are not subject to self-employment taxes on the corporation’s income. An LLC’s members are generally subject to self-employment tax on their distributive share of ordinary trade and business income.

Retention of Earnings

A C corporation’s income does not flow or pass through to its shareholders, and dividends are only taxed when cash is distributed to the shareholders. This can make it easier to retain and accumulate capital. The current corporate tax rate is 21 percent. LLC’s pass-through taxation makes conservation of operating capital difficult. LLC owners are taxed on their distributive share of the LLCs income, regardless of whether any cash is distributed. This is why LLC agreements usually require the LLC to distribute cash to the members to enable them to pay their taxes on their share of the LLC’s income.

If you form as a C corporation, you pay 21 percent federal income tax on your profits. If you form as an LLC, you may have to agree to distribute more than 21 percent of your taxable income to your LLC members so that they can pay their taxes on the entity’s income.

State Income Tax Return Filing Requirements

Each member of the LLC may be required to a file a tax return in multiple states. This is not the case with C corporations. Since C corporations are not pass through entities, shareholders of C corporations do not need to worry about suddenly having to file state tax returns in new states. If you are an angel investor who lives in Washington State, for example, which doesn’t have an income or capital gains tax, and you don’t otherwise file a California income tax return — it could be kind of a bummer to suddenly receive a California Form K-1 and have to file a California tax return.

Complexity/Uncertainty

The flexible nature of LLCs makes them more complex. Partnership tax is also substantially more complex than C corporation tax. The relatively new nature of the LLC form and limited amount of case law and legal documentation that has developed compared with corporate paperwork make LLC transactions more complex and uncertain than their corporate counterparts.

Tax Rates

Individual tax rates can be higher than C corporation tax rates. The highest corporate tax rate right now is 21 percent. The highest individual federal income tax rate is 37 percent. State income tax rates vary by state (from nothing in Washington State to 13.3 percent in California).

Administrative Burdens

Partnership tax accounting is more complex than C corporation tax accounting. In an LLC, typically everyone’s ownership in the entity is determined by reference to their capital accounts. Capital account maintenance can be time consuming and expensive, and it is not something you encounter with a C corporation.

Withholding on Foreign Member’s Distributive Shares

An LLC has to withhold taxes on certain types of income allocated to foreign persons, regardless of whether distributions are made. C corporations are not subject to this requirement. For more information, see: Helpful Hints for Partnerships With Foreign Partners.

With LLCs, Owners Can’t be Employees for Federal Income Tax Purposes

If you are not an employee of an LLC, and you become an owner, you can no longer be deemed as an employee for federal income tax purposes. This sets up a situation where, in order to avoid this problem, you might want to form another entity through which to employ the employees of the business, adding a layer of complexity not present in the C corporation context.

Editor’s note: Throughout this article when we refer to an LLC we are referring to an LLC taxed as a partnership, not an LLC taxed as a C corporation, or an S corporation, or as a disregarded entity.


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Joe Wallin

Joe Wallin is a leading startup lawyer in the Pacific Northwest and the founder of the Law of Startups. He represents companies from inception to exit, as well as investors, executives, and founders. His practice focuses on startups and emerging companies, angel and venture financing, and M&A transactions. Follow him on Twitter @joewallin