By now most entrepreneurs who have sought or will seek venture funding have learned that venture capitalists typically prefer to invest in C Corporations and will not invest in pass through entities such as a limited liability company; in many instances owners of interests in venture funds, such as pension funds, will require opt out provisions from any investment into a pass-through entity like an LLC. Venture funds are also reluctant to invest in S. Corporations as those entities are only allowed to have one class of stock and therefore will not allow for the separation of common stock and preferred stock, a common feature in almost all venture transactions. The venture capitalist preference for the C. Corp puts it at odds with many early stage entrepreneurs, as those individuals prefer to register as LLCs or S. Corps in the early stages. This is to done mostly to avoid the double taxation that comes with registering as a C. Corp (C. Corps are taxed on earnings both at the entity level and when earnings are paid out to shareholders). So how do we solve this apparent clash of interests?
What can I do if I have registered an LLC or an S. Corp and want to receive funding from individuals who only invest in C. Corps?
Certain types of corporate acquisitions, divisions and other restructurings can be structured to qualify as tax-free reorganizations for US federal income tax purposes. If the requirements of a tax-free reorganization are satisfied, the parties generally defer current US federal income tax on gains on their stock and asset transfers. For early stage entrepreneurs who have registered an LLC or S Corp there is an option to turn your entity into a C Corp via a tax-free reorganization. The reorganization is referred to as an “acquisitive reorganization.” In these transactions one corporation acquires substantially all of the stock or assets of another corporation. So the owner of an LLC can create a new C Corporation and have that C Corporation acquire all the assets (and liabilities) of the LLC and the resulting entity will be a stand alone C Corporation. In these transactions one requirement is that stock of the acquiring corporation (the newly-formed C Corporation) must be used as a significant portion of the consideration, although in some instances parties can be paid using consideration other than qualifying stock (known as “boot”). Therefore, the owner(s) of the LLC must end up owning a large portion of the C Corporation stock. The diagram below shows how this type of organization will look as the stock from the acquiring corporation (the C Corporation) will be paid to the owners of the target corporation (in this case an LLC) and the target will merge into the acquiring company resulting in the both groups of stockholders owning an interest in the target corporation.
What are the requirements for a tax-free reorganization?
Generally, for these types of reorganizations to qualify for tax-free treatment they must meet specific statutory requirements and must also satisfy three judicial requirements. The first is “continuity of interest.” Continuity of interest requires that the stockholders of the initial company (in our example the LLC) receive a substantial equity interest in the acquiring corporation (the newly-formed C Corporation). The second requirement is “continuity of business enterprise.” This requirement is met when after the transaction the acquiring corporation continues to deal in the main business of the target company, e.g., if Acme LLC sold widgets it must continue to sell widgets when it becomes Acme Corp. The third requirement is the “continuity of business purpose.” This requirement is met if there is a bona fide business reason for the reorganization and not simply done for tax savings. In our example, the company LLC will have a bona fide business reason as it is reorganizing to gain funding that it otherwise could not get if it remained as an LLC.
Tax Benefits of these transactions
Before a tax-free reorganization, the target corporation may have valuable tax attributes that can be used to offset its taxable income and the acquiring corporation may want to obtain access to those pre-reorganization tax attributes. One example of a valuable tax attribute is net operating
losses (NOLs). A taxpayer has a NOL when its allowable deductions exceed its gross income in a specific taxable year. In a transaction that is structured like the one in the example above, the acquiring corporation obtains access (directly or indirectly) to the pre-reorganization tax attributes (such as NOLs) of the target corporation, subject to several limitations that you should discuss with a tax or legal advisor to gauge how these rules apply to your transaction. However, some of the most significant limitations on the use of the target corporation's tax attributes after a tax-free reorganization are IRC §§ 269 and 382.
While it is true that it is preferable to register as a C Corporation if you aim to seek venture funding, failing to do so is not fatal. In the event that a company starts out as a disregarded entity such as an LLC it is possible to reorganize, subject to certain statutory and judicial requirements, and become a C Corporation and put yourself once again in a position to receive venture funding. As with most of these issues, dealing with a legal or tax advisor to assist in your transaction will help considerably in ensuring that each step complies with state and federal regulations associated with these types of transactions.
If you are considering a tax-free reorganization in connection with preparation for venture funding please feel free to contact one of our attorneys at firstname.lastname@example.org or visit our website atwww.rbernardllp.com to learn more about our services. Follow us on Twitter.