Guest Column by Gregory S. Fryer, of Verrill Dana LLP
Congratulations, you have decided to launch a new business. But what type of legal entity should you choose? For many businesses, an LLC is a good option — more companies are formed as LLCs than as corporations— but for companies hoping to raise significant capital from outside investors, my go-to rule of thumb is “C corp unless you give me a great reason to conclude otherwise.”
The LLC is wonderfully flexible, and for many lawyers and tax accountants it is their standard choice. If your business will not be raising much outside capital, or has the luxury of a large legal budget, the LLC can be a terrific vehicle. But for high-growth startups that will need hundreds of thousands of dollars of outside capital, here are five good reasons to favor the C corporation:
- Upfront Expenses. Even with a one-size-fits-all LLC form (not recommended), the LLC will usually involve greater legal and tax preparation expenses each and every year. Ultimately the C corporation might end up not being the tax-optimal entity, but simplicity and lower cost can be important attributes in the early years.
- Tax Returns. Buying stock in a C corporation will not complicate your investors’ tax returns until the business starts paying dividends (a happy day!) or until they resell their shares. In contrast, buying an interest in an LLC complicates the investors’ tax returns from day one, usually without any immediate benefit to offset the early hassle and expense. Only down the road will you really know whether the LLC was a better tax choice.
- Stock Options. If your plans include “stock options” or “stock grants” to encourage employee loyalty and reduce salary levels otherwise paid in cash, the C corporation works great but the LLC is, at best, an awkward fit.
- Multiple Investor Rounds. LLCs are simplest where everyone shares pro rata (akin to Common Stock for everyone). An LLC can also do a good job accommodating a Series A round with a priority return for investors. By the time you get to a Series B round or higher, though, LLC complexities can send your drafting and negotiating costs through the roof. High-quality, off-the-shelf investor documents are readily available for C corporations and can easily accommodate B and C rounds. Translating these to LLCs is difficult, imperfect, and expensive.
- IRC § 1202. If you organize a C corporation and the business does prove successful, this little-known Tax Code provision can allow your investors (and you!) to avoid 100% of all federal capital gains taxes on future resales of stock. The details are beyond the scope of this article but do look it up or ask your lawyer or tax accountant whether your company is a good candidate. A very, very generous tax benefit.
Books have been written on how to choose the right legal entity, but I hope the five reasons discussed above cause you to think twice about whether the LLC is the right choice for your business.