What’s the Best Choice of Entity?

When we work with founders to start their business, the question of which type of entity to form is often their first question. For many high-growth companies that are planning to obtain outside financing, forming a C corporation is often the right approach, especially if venture capital funding is expected soon after formation.  

Corporations have a number of advantages over other types of entities, particularly when it comes to (1) granting equity to employees and advisors, (2) raising money from venture funds and other investors, and (3) receiving particular tax benefits at an exit.

Equity Grants

First, corporations allow founders to issue equity in a straightforward way. Corporations can grant service providers stock options through a customary stock option plan. Limited liability companies taxed as partnerships[1] (“LLCs”), on the other hand, while able to issue equity options, do not have the ability to issue tax-favored “incentive stock options” and instead often incentivize service providers by using “profits interests” or phantom equity because of their more favorable tax treatment than “regular” equity options. These, however, are significantly more complicated and administratively burdensome. In addition, potential service providers may not be as well versed in the mechanics of profits interests and may expect more traditional stock options as part of their compensation.

Financing

Second, corporations are best positioned to raise money from investors. Venture capital funds are often unable or unwilling to invest in LLCs. Some of the reasons for this include the administrative burden of LLCs and qualified small business stock issues (discussed in detail below), but it primarily is due to tax consequences for certain types of investors in the venture capital fund if the fund invests in LLCs. While it is possible to convert an LLC to a corporation in connection with a financing round, the process can be complicated and costly, and will ultimately delay the closing of the financing and receipt of the funds by the company. For this reason, forming a corporation from the outset can be advantageous.

Tax Considerations

Lastly, certain stockholders in C corporations may be able to receive certain tax benefits in an exit. The equity interests of a qualifying corporation may be able to qualify as qualified small business stock (“QSBS”) under Section 1202 of the Internal Revenue Code of 1986, as amended. Section 1202 allows stockholders to be exempt from federal income tax on up to $10 million (and possibly more) of the gain from a sale of QSBS if certain requirements are met. Section 1202 status is an attractive benefit for venture capitalists and other equity holders of a company. Ownership interests in LLCs cannot qualify as QSBS. Our article on QSBS and its benefits provides additional background on this point: https://www.wyrick.com/news-insights/qualified-small-business-stock.

Another tax-related consideration is that corporations can elect to be taxed as either C corporations or S corporations. The C corporation is the default tax status for corporations, but corporations meeting certain conditions may elect to be taxed as an S corporation with the IRS. S corporations maintain tax advantages similar to LLCs in that they avoid double taxation. However, S corporations also have a number of potential disadvantages. S corporations can only have one class of stock (so cannot accept venture capital funding, which generally requires equity with preferential economic terms), and the number and type of stockholders that S corporations can have are limited. In addition, S corporations are not able to issue QSBS, which could negatively impact financing for such businesses. Corporations intending to be widely held and/or obtain outside financing are unlikely to be able to maintain S corporation status. As such, the C corporation has a number of advantages that make it a better choice for most founders.

There are, however, certain instances where a different structure such as an LLC may be the best option. By default, LLCs with multiple owners are taxed as pass-through partnerships, meaning the company’s profits and losses are passed on to the members of the LLC (avoiding the double taxation issue found in C corporations). LLCs may, however, make an election with the IRS to be taxed as either C corporations or S corporations. This flexibility and tax advantage is worth considering for businesses that don’t intend to scale or seek outside institutional investors during the life of their company.

Another potential benefit of formation as an LLC is that the company can later be converted into a C corporation and, if the stock issued in the conversion in exchange for LLC interests qualifies as QSBS, a stockholder may be able to exclude more than $10 million of gain from federal income taxes when the QSBS is sold (if the stockholder’s interests is worth more than $1 million at the time of conversion).

LLCs also offer a more flexible governance structure, as they can be managed by either their members, one or more managers, or a board of representatives or managers, which is similar to the board of directors of a corporation. Corporations have less flexibility in this regard (as they must be governed by a board of directors), and there are more stringent corporate law formalities that corporations must follow (for example, regular board and shareholder meetings must be held).

NOTICE:  This article is intended to be a summary of some key factors to be considered by high-growth companies that are planning to obtain outside financing when making decisions regarding entity formation, and is not written tax or legal advice directed at the particular facts and circumstances of any person or company. Please note that not all potential details and nuances that may be important for a particular person or company regarding these considerations have been addressed. As a result, founders should always consult with their accountants and legal advisors with respect to their individual circumstances.

[1] Note that for purposes of this article, the assumption is that LLCs with multiple members are taxed as partnerships and that no election has been made otherwise.