Startups founders frequently choose to make their companies LLCs, which ends up causing a number of issues as the move forward. I recently came across the Startup Law blog and the author has a number of really good articles about business entities. Below is an excerpt from a fairly comprehensive one on the pluses and minuses of different company formations.
Choice of Entity/Significant Tax and Other Considerations
The following is a high level summary of some of the more important federal income tax and non-tax considerations involved in choosing between doing business as an entity taxed for federal income tax purposes as:
- a C corporation (C Corp);
- an S corporation (S Corp); and
- a partnership (such as a multi-member limited liability company (LLC) that hasn’t checked the box to be taxed as a corporation).
C Corporations v. S Corporations
C Corporation Advantages/S Corporation Disadvantages
- Traditional Venture Capital Investments Can Be Made – C corporations can issue convertible preferred stock, the typical vehicle for a venture capital investment. S corporations cannot issue preferred stock.
- Investors Won’t Be Taxed on the Entity’s Income and Receive A Form K-1 – Many investors will refuse to invest in a company if they will be taxed on the company’s income and will receive a Form K-1 reporting such income to them as a result of the investment. This is not the case with C corporations, but it is the case with S corporations.
- Retention of Earnings/Reinvestment of Capital – Because a C corporation’s income does not flow or pass-through to its shareholders, C corporations are not subject to pressure from their shareholders to distribute cash to cover their shareholders’ share of the taxable income that passes through to them. An S corporation’s pass-through taxation may make conservation of operating capital difficult because S corporations typically must distribute cash to enable shareholders to pay the taxes on their pro rata portion of the S corporation’s income (S corporation shareholders are taxed on the income of the corporation regardless of whether any cash is distributed to them).
- Eligibility for Qualified Small Business Stock Benefits – C corporations can issue “qualified small business stock.” S corporations cannot issue qualified small business stock, thus S corporation owners are ineligible for qualified small business stock benefits, such as the 50% gain exclusion for gain on the sale of qualified stock held for more than five (5) years (for an effective capital gains rate of 14%) and the ability to roll over gain on the sale of qualified stock into other qualified stock.
Until the end of 2013, individuals receiving “qualified small business stock” from C Corps may be able to take advantage of the 100% exclusion from tax (up to $10M in gain), including AMT, under Section 1202 of the IRC, if they hold the QSBS for longer than 5 years. This is a significant potential benefit not available for S Corps.
- No One Class of Stock Restriction – S corporations can only have one class of stock; thus, S corporations cannot issue
- preferred stock. This restriction can arise unexpectedly, and must be considered whenever issuing equity, including stock options or warrants.
- Flexibility of Ownership – C corporations are not limited with respect to ownership participation. There is no limit on the type or number of shareholders a C corporation may have. S corporations, in contrast, can only have 100 shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders (all shareholders must be U.S. residents or citizens).
- More Certainty in Tax Status – A C corporation’s tax status is more certain than an S corporation’s; e.g., a C corporation does not have to file an election to obtain its tax status. S corporations must meet certain criteria to elect S corporation status; must elect S corporation status; and then not “bust” that status by violating one of the eligibility criteria.
- No State Income Tax Complications for Investors. Shareholders of an S corporation may be subject to the income tax of various states in which the S corporation does business. This doesn’t happen to C corporation shareholders.
S Corporation Advantages/C Corporation Disadvantages
- Single Level of Tax – S corporations are pass-through entities: their income is subject to only one level of tax at the shareholder level. A C corporation’s income is subject to tax 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 (i.e., income is effectively taxed twice). This rule is also generally applicable on liquidation of the entity.
- Pass-Through of Losses – Generally losses, deductions, credits and other tax benefit items pass-through to a S corporation’s shareholders and may offset other income on their individual tax returns. These returns are subject to passive activity loss limitation rules, at risk limitation rules, basis limitation rules, and other applicable limitations. A C corporation’s losses do not pass-through to it shareholders.
C Corporations vs. LLCs
C CORPORATION ADVANTAGES/LLC DISADVANTAGES
- Traditional Venture Capital Investments Can Be Made – The issuance of convertible preferred stock by C corporations is the typical vehicle for venture capital investments. Venture capitalists typically will not invest in LLCs and may be precluded from doing so under their fund documents.
- Traditional Equity Compensation is Available – C corporations can issue traditional stock options and “incentive stock options.” It is more complex for LLCs to issue the equivalent of stock options to their employees. “Incentive Stock Options” also are not available to LLCs.
- Investors Won’t Be Taxed on the Entity’s Income and Receive A Form K-1 – Many investors will refuse to invest in a company if they will be…
Read the complete article at the Startup Law Blog