Registering your startup: LLC vs C Corporation
The general consensus is that startups planning on raising outside capital from venture capital firms and startups investors should incorporate as C Corporations instead of as LLCs.
Many entrepreneurs are drawn to LLCs because an LLC is a highly flexible customizable entity through which a company could set up structures similar to a corporation. Instead of issuing stock like a corporation, an LLC can create membership interests, including different classes of ownership with different voting rights. In many jurisdictions, it can be easier to set up and maintain an LLC. Given all this, why don’t startup companies use LLCs more often?
The short answer is: startup investors have a strong preference for C Corporations, primarily because of tax implications and a few other key considerations. Here is what you need to know to decide on whether to use an LLC or a C Corporation for your startup.
Why do startup investors prefer C Corporations over LLCs?
Most venture funds and startup investors prefer C Corporations due to the tax implications. Tech startups choosing between an LLC and a C Corporation will want to keep this in mind, as it may be difficult to raise capital for a business registered as an LLC.
QSBS Exemption for Investments in C Corporations
The biggest tax advantage to investing in startups that are registered as C Corporations is the Qualified Small Business Stock (QSBS) exemption. LLCs are not eligible for this tax exemption, and LLCs that convert into C Corporations are also not eligible. If you already registered as an LLC, fortunately, it may be possible in some circumstances to dissolve your LLC and transfer the assets to a newly registered Delaware C Corporation.
For an investment to be eligible for this exemption, under section 1202 of the Internal Revenue Code (IRC), the stock must be purchased by the investor when the company was worth less than $50 million dollars — most early stage startup investments qualify, since typical seed round valuations are around $5-10 million.
If the investor then holds the shares for 5 years or more before selling, they can exclude 50% (and sometimes 100%) of the gain realized from the sale of the shares when paying their income taxes. Finally, the investors can also defer the recognition of the profits from their investments in QSBS stock on their tax returns if they turn around and re-invest the profits into a new investment in a startup that qualifies as QSBS at the time of investment.
LLC investments can create problems for non-profits investing in venture funds as limited partners
LLCs can present a problem for venture funds that have tax-exempt non-profit entities investing as limited partners in the venture fund. Some venture funds may have pension funds, university endowments and other non-profit entities as limited partners. Investments in LLCs can trigger UBTI (unrelated business taxable income) for these non-profit entities, which can undermine their classification as tax-exempt. There are workarounds involving the creation of a special purpose investment vehicle, but setting up these entities can be a big hassle and presents an extra expense to completing a venture financing.
Investing in LLCs creates extra complexity for due diligence
LLCs are highly flexible and easy to customize legal entities. That is both a blessing and a curse. When it comes time to raise a huge financing round from investors, LLCs are often much more complex to evaluate from a diligence perspective.
C Corporations have conventional structures in place for issuing multiple classes of stock to shareholders. VC investors will typically seek preferred stock, which enables investors to secure rights and privileges specific to the preferred class of shares they own, including liquidation preferences, rights to board seats, pro rata rights to maintain their ownership percentage in future financing rounds, and so on.
LLC’s cannot issue stock like corporations; instead, LLCs grant “units” or “ownership interests” in the company and set up preferential rights that function similarly to preferred stock in a C corporation. However, this ownership structure is much more complex (and potentially quite costly) since there isn’t a conventional model for implementation, like the issuance of preferred shares in a C Corporation.
Investors will often be unfamiliar with the corporate structure in LLCs, creating more work on their part to review and understand investment terms, and there will be more uncertainty around various deal mechanics. Keep in mind, with LLCs, there are often fewer case precedents for shareholder and investor disputes, so working outside of the conventional C Corporation structure can create uncertainty around what is judicially enforceable.
Many founders are not aware that, as part of the terms of most venture financings, they are typically on the hook for paying their investors’ legal fees. Using an LLC structure for your startup is likely to substantially increase your company’s expenditures on legal fees down the road, for both internal counsel and financing-related legal bills.
How does the choice of LLC or C Corporations affect my personal taxes as a founder?
You might hear advice from other business owners about why LLCs are advantageous for your personal taxes. It is true that the profits from an LLC can be treated as pass-through income flowing directly to your personal taxes. This avoids what is known as “double taxation” — where the profits of your business are taxed at the corporate level, then you are taxed again when you pay yourself a salary from your corporation.
While this may sound like sage advice, it likely does not apply to most startups. As a startup founder, you should expect your business to take at least 2-3 years to become profitable, if not longer, meaning any concerns about “double taxation” are simply not applicable.
The reality is that, when it comes time to file your personal tax returns, you won’t be paying a high tax rate as a founder at an early stage startup. You will only be able to afford to pay yourself a small salary (if any salary at all!) until your company is generating revenue and has raised substantial amounts of capital from outside investors.
Registering your company as a C Corporation can result in potential tax benefits for founders. The QSBS exemption for startup investors that we discussed above also applies to your founders shares. If you hold your shares for 5 years or longer before selling them, you will possibly be able to exempt up to 100% of the proceeds from selling these shares when it comes time to pay your tax bill!
Issuing Equity to Employees: LLCs vs C Corporations
Many startups try to incentivize employees by offering them equity in the company as part of their compensation packages. Since startups often can’t compete on salary with bigger companies, they are able to retain top talent by offering generous stock options to early employees.
The process of issuing equity to employees in an LLC is vastly more complex with an LLC compared to a C corporation. Read about how issuing equity to employees in an LLC is different from issuing equity in a C corporation in more detail.
- VCs *strongly* prefer to invest in C Corporations 99% of the time
- Investing in C Corporations has major tax advantages for startup investors
- LLCs can be complicated to diligence as part of venture financing, increasing costs and time to close fundraising deals
- LLCs allow for owner income to be taxed as pass-through income; in practice, startup founders will rarely be able to take advantage of this tax treatment
- The proceeds from selling founder stock in C Corporations can be 100% tax exempt from federal income taxes as long as the company stock qualifies as Qualified Small Business Stock (QSBS) a the time of purchase