In counseling entrepreneurs, one of the first questions that arises is about choice of entity type – in other words, should the entrepreneur’s business be contained in a C corp, S corp, LLC, limited partnership or general partnership, or be structured in some other way? While there are obviously a number of factors that must be considered when answering this question, my answer is – with few exceptions – that an LLC is the best form. This is not yet the universal view, and some excellent attorneys have a different predisposition. So, I’ll lay out my basic reasons here, and I’ll be curious for comments – especially from people with a different viewpoint.
To keep it simple, my reason is that an LLC provides the benefit of limited liability for the owners, pass-through tax treatment (that is, no double tax), and ultimate flexibility in structuring the equity ownership and management rights of owners. No other entity form has this combination of features.
I sometimes word my advice on when to switch from an LLC to a C corp in this way: “when dragged kicking and screaming into being a C corp”. The main downside of C corps is that they result in double tax – once at the corporate level, and once again when profits are distributed to owners. Even if the profits are not distributed, upon the sale of the business there will either be two levels of tax (in case of a sale of assets) or an implicit reduction of sale price (in case of a stock sale that does not permit a write-up of the value of the assets for tax purposes).
Here are three main downsides to LLCs, along with my counter-arguments:
- First, the legal and accounting costs to set them up and administer them properly are somewhat higher than with corporations. This is true – with all the flexibility comes some complexity, and partnership (pass-through) accounting is, I believe, intrinsically more difficult than corporate accounting. However, the effect of double taxation can be almost 15 percentage points of tax on all of the business’ profits and ultimate exit value (above the original investment). Such big dollars, in my view, outweigh the transaction costs and complexity of operating an LLC.
- Second, most venture capital firms don’t want to (or refuse to) invest in LLCs. This is also true, at least for now. The most common and well-understood form of venture investment is still preferred stock in a corporation, and it is difficult to exactly match that in an LLC. Also, something called UBTI (unrelated business taxable income) that can result from ownership in a pass-through entity, can create a problem for some VCs. I have three responses to this: (1) a small but growing number of VCs, and even more strategic investors, are willing to invest in LLCs to get the tax savings; (2) a transaction can be structured so the VC invests through a “blocker” C corp that, in turn, invests in the LLC; and (3) this is no reason to start out as a C corp – only to become one later if you have a VC that is willing to invest and demands it (getting a lot of capital is a good reason to let go of the “kicking and screaming”).
- Third, equity compensation arrangements for employees are somewhat more complicated in LLCs than in corporations. Again, guilty as charged. In corporations, the tried-and-true method – albeit not without its own problems – is stock options. In LLCs, the most common method is “profits interests”, which are inartfully named but are in fact equity interests in the LLC. More on these creatures in another post, but, again, I view the absolute dollars of tax savings as outweighing the challenges of equity compensation in LLCs.
Please share your experience and views on these topics.