In the frantic life of a startup, founders often find themselves making countless decisions, day in, day out. The rapid-fire nature of this process often leaves founders wondering: “Will this decision significantly affect the future of my company?”
Fortunately, for most decisions, the answer is “no.” But there is one major choice that can significantly affect the future of your company — the type of business entity you form.
I am regularly approached by startup owners wondering whether to become a C Corporation, an S Corporation, or an LLC (a limited liability company). This is one of the most important choices a fledging startup can make, because it will profoundly impact the ability to raise investment money, which in turn will impact the future direction of the company.
What are the different types of business entities for startup incorporation?
To understand the impact of which business entity you choose to form, it helps to first understand the three basic types you can choose from. All offer the owner(s) limited liability for business debts and obligations. What differentiates them from each other — and what matters most to investors — is their federal income tax characteristics.
An S Corporation is not subject to federal income tax. Instead the company’s shareholders pay federal income tax on the taxable income of the S Corporation’s business based on their pro-rated stock ownership.
Like S Corporations, LLCs are “pass-through” entities, which means that their owners (known as members) pay tax on the portion of the LLC’s income that is allocated to them based on the LLC agreement. For LLCs with multiple members — which is exactly what happens when you have investors — the LLC is treated as a partnership, and the members of the LLC are treated as partners for federal income tax purposes.
Unlike an S Corporation or an LLC that’s treated as a partnership, C Corporations are subject to state and federal income tax on its net income — that is, the income that is realized after expenses (including salaries) are paid. Shareholders are not subject to tax unless the corporation pays them in the form of dividends, distributions, or salary. However, since dividends are paid from net income, shareholder dividends are effectively taxed twice — once when the corporation pays tax on its net income, and again when the shareholder gets the dividends. (RELATED: Why VCs Only Invest in C Corporations)
What’s wrong with LLCs for startups?
Tech companies that need to raise capital to grow their companies may find it much more challenging to woo investors if their startup is an LLC. Here are four reasons why investors may shy away from an LLC startup.
1. Many investors don’t like the tax implications of an LLC.
Investors often don’t want to complicate their personal tax situation by becoming a member of an entity (i.e. an LLC) that is taxed as a partnership, because as a partner, they’ll be taxed on the entity’s income even in years when no cash is distributed to them personally.
2. Many investors can’t invest in LLCs.
Some investors, such as venture capital funds, can’t invest in pass-through companies such as LLCs, because the VC fund has tax-exempt partners that can’t receive active trade or business income due to their tax-exempt status.
3. Investors are potentially taxed in other states.
If the business has an active trade or business in other states, passive investors may become subject to income tax in those other states. A similar thing happens when non-US persons invest in US LLCs. This is a major turn-off for investors.
4. Many investors prefer owning stock in a C-Corp.
Investors in early-stage businesses usually just want to make a simple investment, acquire a capital asset (the stock), and avoid any intervening tax complications until the stock is sold and there’s a capital gain or loss event.
Why you shouldn’t worry about the “double tax” of a C-Corporation
Inevitably you’ll hear that you shouldn’t form a C-Corporation because you’ll be subject to a “double tax.”
In some ways, this is true. A C-Corporation pays tax on net income — that is, income after expenses and salaries. If the C-Corporation uses that net income to pay dividends to its shareholders, those shareholders will pay tax on the dividends. However, for most growing businesses, whose goal is to raise capital, reinvest capital, grow fast, grant equity incentives, and ultimately be acquired or go public, the double-tax penalty rarely applies.
The Bottom Line: To LLC or Not To LLC?
When my startup clients ask what kind of business entity they should go with, I typically advice them to choose a C Corporation. That’s because other structures can be an inconvenience to future investors and you don’t want to put obstacles between you and future capital for your growing business!
Enjoyed this post? Read on with Why VCs Only Invest in C Corporations.
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