Top Legal Mistakes Entrepreneurs Make: Choice of Entity

By: Gregory J. Lynch 

One of the first legal issues entrepreneurs face is what type of entity they should form. There are three common types of entities: C-corporation, S-corporation and limited liability company (or LLC). There is a lot of confusion on which entity is best. Some experienced West Coast start-up lawyers provide a five second answer that a corporation is recommended. Some law firms in the Upper Midwest consistently recommend limited liability companies, while our former colleague Matt Storms identifies key deficiencies in LLC’s. This article will briefly describe the pros and cons of C-corporations, S-corporations and limited liability companies. In general, while limited liability companies are a good option for companies who are not going to seek material outside angel or venture capital financing, high-growth companies who will rely on angel or venture capital financing should not form limited liability companies.

All three types of entities provide the basic liability protection against personal liability for obligations of the business. C-corporations, S-corporations and limited liability companies differ significantly in the areas of taxation, financing, ownership and structuring flexibility and financing. These key differences are summarized in the following chart and described in more detail below.

  C Corporation  S Corporation LLC
 
Pass-Through Tax Treatment  No Yes Yes
Flexibility of Ownership and Capital Structure  High Low High
Attractive to Founders  Maybe Maybe Maybe
Attractive to Investors  Yes No No
Complexity  Moderate Moderate Moderate to High
Costs  Small to Moderate Small to Moderate Small to High
Ideal Profile VC or angel backed company Early stage company that intends to convert to C Corporation within 24 months but founders want initial tax losses Companies that will not seek material outside investment

 

Taxation

  •  C-Corporations. A C-corporation is a separate taxable entity. As such, its earnings or losses are taxed at both the entity level and, to the extent any distributions are made, at the stockholder level. The impact of this double taxation is mitigated for companies that anticipate generating losses for the foreseeable future.
  • S-Corporations. Unlike a C-corporation, most profits and losses of an S-corporation flow through to the individual income tax returns of its stockholders. However, several rules can limit the ability of stockholders to utilize any S-corporation losses that are passed through to them. One rule states that stockholders generally can not deduct S-corporation losses in excess of the amount invested in the stock and any funds loaned to the S-corporation. A second rule further limits the ability of S-corporation stockholders who are not actively involved in the business to offset tax losses against other “nonpassive” income (e.g., dividends, interest, royalties, etc.). In contrast, S-corporation stockholders who are actively involved in the business (e.g. founders) can use any losses passed through from the S-corporation to offset other income from dividends, interest, royalties, etc. Ownership rules (described below) effectively prohibit venture capital firms from investing directly in S-corporations. When combined with the increased administrative costs of preparing individual Schedule K-1s for every stockholder, S-corporations are very unappealing for operating companies who rely on selling stock to raise capital for growth.
  • Limited Liability Companies. The tax treatment for LLCs is somewhat similar to S-corporations except that (i) LLCs have more flexibility in allocating income or losses to specific investors and (ii) as of now, employee-owners of LLCs are required to pay their own payroll taxes (i.e. income, social security and Medicare) rather than rely on the LLC to remit such taxes on their behalf. The net result is a higher marginal tax liability for such employee-owners. In addition, many venture capital firms are unwilling to invest directly in LLCs because of the risk that certain tax-exempt owners of the venture capital firm would become liable for a special income tax (referred to as “unrelated business taxable income”) on any pass-through of income from the LLC. Finally, the Schedule K-1 administrative burden described above also applies to LLCs.

Ownership / Structuring Flexibility

  • C-Corporations. A C-corporation has tremendous flexibility in who can be a stockholder and in structuring the rights of various stockholders, including with respect to valuation, preferences and protections.
  • S-Corporations. The biggest disadvantages of S-corporations are that they are very inflexible with respect to who can be stockholders and how stockholders can structure their rights. Specifically, S-corporations are limited to no more than 100 stockholders and all of them must be (i) individuals who are U.S. citizens or residents, (ii) estates, (iii) certain eligible trusts or (iv) certain tax-exempt entities.
  • Limited Liability Companies. Like C-corporations, LLCs have tremendous flexibility in who can be a member and in structuring the rights of various owners, including with respect to valuation, preferences and protections.

Financing

  • C-Corporations. A C-corporation is the best entity for seeking outside capital. Almost all venture capital firms and many angel groups will only invest in C-corporations due to the tax and administrative issues described above. We recently spoke with one prominent angel investor who said he refuses to invest in any more LLCs or S-corporations because he had 27 Schedule K-1s and was spending an inordinate amount of money on his personal tax returns.
  • S-Corporations. S-corporations are generally not a good choice for financing because they have the challenges of pass-through taxation described above. In addition, S-corporations have limited flexibility for capital structure and ownership. However, S-corporations can be an ideal bridge entity for companies that want initial pass-through tax treatment before converting to a C-corporation in connection with an outside financing.
  • Limited Liability Companies. Limited liability companies are generally not a good choice for financing because they have the challenges of pass-through taxation described above. Although LLCs do not suffer from the same inflexibility in capital structure and ownership that S-corporations do, LLCs are much harder and more expensive to convert to C-corporations. While S-corporations can be converted to C-corporations at no cost, converting an LLC to a C-corporation can sometimes cost thousands or tens of thousands of dollars in administrative costs (and sometimes trigger income tax upon the conversion). In almost all cases, this unnecessary expense could have been avoided if the founders had not selected an LLC as the choice of entity at the formation stage.

Conclusion

So which choice of entity is best?  There is no single “right” answer for every business. However, the following start-up company profiles are best fits for the three major entities.

  • C-Corporations. A start-up company that is or will have its growth funded by venture capital or angel investors.
  • S-Corporations. A start-up company that intends to convert to a C-corporation in connection with an outside financing but whose founders want the initial benefits of pass-through tax treatment.
  • Limited Liability Companies. A real estate company or a start-up company that is not relying on traditional venture capital or angel investors to fund their growth.

Disclaimer

This Blog is a publication of Michael Best & Friedrich LLP and is intended to provide clients and friends with information on recent legal developments. This Blog should not be construed as legal advice or an opinion on specific situations. For further information, feel free to contact authors or other members of the firm. We welcome your comments and suggestions regarding this Blog. © 2010 Michael Best & Friedrich LLP. All rights reserved.

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3 thoughts on “Top Legal Mistakes Entrepreneurs Make: Choice of Entity

  1. I wonder if it’s more or less costly to convert from and LLC to a C at a later time if founders decide to seek outside investors.

    The stuff about investors doing a S to pass a startup’s losses through to founders and then converting to C once they seek outside investors was interesting.

  2. Charles: Yes, it can be more expensive to convert from a LLC to a C-Corporation later, depending on a variety of factors, including how many states the company is operating in and whether any third-party consents are required. The costs of conversion can range from a few hundred dollars for an early-stage company with no operations operating in one state to tens of thousands of dollars for a company in multiple states.

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