Saturday, April 25, 2009

Choosing a Business Structure LLC Vs C-Corp Vs S-Corp

As promised, here is the follow-up question submitted by Jon who is debating the merits of selecting an LLC or a C-Corporation or an S-Corporation, as well as wondering where to setup such an organization.

In general, I would lean to forming an LLC because it's very easy to setup, you can do it yourself, and the fees for setting it up (not counting California) are pretty inexpensive. You gain the limited liability that you need, and you get pass through accounting for profits and losses without the "double taxation" you have with a C-Corporation.

Sounds great, right? Well in most cases, it is, and this is is why you see so many businesses setup as LLCs today. My first business was an S-Corp, which offered many of the same benefits, but this was before LLCs even existed. Since then, all of my businesses have started as LLCs. As they grew, they changed to C-Corporations for reasons I'll explain below.

Jon writes:

First off, I guess for what type of entity to setup the main issue I had originally was whether to be an S corp or LLC. It seems those 2 would be the best ways to go for my buddy as far as protecting his personal assets and the pass through taxation. LLC seems a bit more flexible than S corp, but the LLC has to pay SE taxes, where I think the S corp either doesn't (or gets to deduct them). Both LLC and S corp avoid the double taxation that a C corp would bring on, right?

LLCs vs. S-Corporations

S-Corporations are subject to many of the same record keeping and procedural requirements as C-Corporations, which is probably something you don't want to mess around with. Likewise, there are also limitations on how you share profits and losses among the shareholders. You probably don't want to mess with that, and LLCs allow you to avoid all that paperwork, and to split profits and losses however your LLC Operating Agreement dictates, regardless of actual shares held.

There are situations where you would want an S-Corp over an LLC, but those are somewhat rare and I've never seen a recent startup need to setup that way. Here again, an attorney might have good advice, but I'll say with pretty high confidence that an LLC is the way to go over an S-Corp for a startup.

Now LLC vs. C-Corporation is a different matter, and might warrant some consideration...

LLCs vs. C-Corporations

The most obvious problem with C-Corporations is that they do not offer the pass through accounting that LLCs (or S-Corps) do, meaning that the Corporation will pay tax on any profits it has, the owner will be paid with a salary just like any other employee, on which they will pay taxes, and if you make profit distributions (by means of dividends), the shareholders will be taxed on that as well. I could easily climb on my soapbox and complain how taxation of dividends is double taxation on the exact same income, and how it leads corporations to make decisions that are not in the best interest of shareholders, and how it encourages gigantic, multi-national, and anti-competitive business evolution rather than profitable, innovative, smaller entities... but THAT is for another day (and probably another blog entirely!)

But, suffice it to say that the tax code is not friendly to the C-Corporation that wants to operate and then provide profits to the shareholders. If those shareholders also work there, then are three different points of taxation. LLCs look like they have only one, but in reality there is a secret second point of taxation because you have to pay self-employment tax in addition to income tax. Don't you love how the government tries really hard to discourage people from working for themselves in the tax code, while paying lip service to how small business drives the economy? Ah, there I go again...

Anyway, paying self employment tax is still (most likely) cheaper than the C-Corp tax, because when you are paid as an employee, the C-Corp will need to make an employment tax withholding on your salary which is essentially the same as the self employment tax. One difference is that with the C-Corp, you might well hold profits in the corporation rather than pay them out, so if you were going to be highly profitable, you might be better served to hold profits there (and avoiding, for a while, the extra taxation) while paying yourself a minimal salary.

Now in a company that's going to experience a period of losses as things ramp up, the LLC has advantages to the owner-operator. LLCs will pass those losses along, and those loses can offset other income the individual might have. In a C-corp, the corporation will carry those losses (for credit against future profits), but the owner-operator, who is an employee, does not get to take those losses. They will have W-2 income and will be taxed accordingly, just as they would if they were an employee at McDonalds or anyplace else.

So ready to jump right in as an LLC? Not so fast -- there are a few more considerations...

The biggest limitation of LLCs, in my experience, is the very limited nature of how you deal with the ownership structure. LLCs do not have shareholders and shares of stock, they have "members" and "units" (nomenclature that is sure to make any fan of 9th grade humor to laugh uncontrollably). On the surface, it may seem that these are just different names for the same thing, but that's not the case.

In an LLC, one member is the same as another member. Everyone is working under the same operating agreement, and if I have 100 units, and you have 100 units, there is no difference between us. An investor, the owner, other employees who have been given ownership -- all these people hold exactly the same type of equity, the unit, and there is no difference between them. There is only one kind of unit in an LLC, and that's that.

C-Corporations are very different. C-Corporations can issue different classes of stock, so an investor might have preferred stock, employees and owners common stock. Those classes can be subdivided further so a investor today might get "Series A Preferred Stock" with certain rights and privileges, and a later investors get "Series B Preferred Stock" with different rights, etc. You might setup a stock option plan for employees to give them ownership in exchange for their work and loyalty to the company, while the owners have common stock, perhaps with a founders stock agreement as described in an earlier question. Vendors might get warrants in exchange for providing discounted services.

In short, there is a lot more flexibility here. Also, there are tax implications. Because an LLC has one kind of unit, the tax is very simple, and perhaps, not very helpful. If an investor puts in money at $10 / unit, and you then give away 100 units to an employee because you want to give them ownership, then you've just subjected that employee to a tax hit. The IRS will say that you "gave" the employee $1000 worth of stuff ($10 * 100 units), and they'll owe income tax, at ordinary income levels, on that gain. So now your good intentions just cost your employee $300+ in taxes. They probably won't like that. So they can either shell out $1000 for the units (fair market value), or you can give them cash along with the units (which they'll also have to pay tax on), so that they can use that cash to pay for the tax on the units you gave them. Especially when you talk about bringing in management team members, who might demand big pieces of ownership, you quickly can have yourself a real mess.

In the C-Corp, you are probably going to create a stock option plan, and use that to give ownership to employees. So long as the option price is equal to the fair market value of the underlying class of stock - at the time the option was granted - there is not taxable event. The expectation is that the company will grow, and by the time the employee vests the stock, it will be worth a lot more than it was when it was granted. The employee will then have to pay tax on the gain if and when they exercise those options, but normally they don't exercise until they intend to cash in those options, and so they are simply paying tax on actual cash they just received, and everyone is happy. It's short term capital gain and not long term capital gain, but when you sell to Google for a cool billion, everyone will be pleased.

A fine point in this is to understand that, in a C-Corporation, all classes of stock are not created equal, and therefore, are not priced the same. Just because an investor buys preferred shares at $10/share does not at all mean that your common shares are also worth $10/share or that your base option price is therefore $10/share. The preferred shares have all kinds of things that make them more valuable, and no knowledgeable person would pay $10 for common when the same $10 gets them a whole lot more with preferred. The board of directors will set the price of common, noted in the minutes, with an explanation of why it's so much less than the preferred shares. It's not uncommon for this discount to be 90% (or more) in a new startup, so a $10 preferred price might mean $1 (or less) for common shares and thus option exercise price.


What's it all mean? Well, here's what I do: When I setup a new company, either on my own or with partners, we setup an LLC. At the point that we need to start dolling out stock options in order to hire more people, or that we need to bring in outside investors, we convert to a C-Corporation. When you're talking investors and employee option pools, C-Corporations are the way to go. If it's just you and some partners trying to make a few bucks, go with the LLC.

If you are only going to raise a little money and never any more, then you can do that with an LLC, but be careful: the last thing you need is a big group of investors, who put money in at all different times in the company's life, with no real distinction or flexibility in how those shares/units work.

Here are a few links to legal information regarding the various structures:

Founder of four companies and an industry trade-group before he turned 29, Jeff Ready defines the word "entrepreneur."

Aureate Media developed a unique ad-serving infrastructure and set of technologies that allowed companies to put advertising directly into computer games and other software applications. Internet Venture Capital firm CMGI invested more than $5 million in the company before Ready re-launched Aureate Media as Radiate, Inc. From there, Ready grew Radiate to become one of the largest internet properties, generating over $20 million a year in sales and reaching with more than 30 million people per month through its technology.

In 2001, Radiate was acquired by a privately-held software firm in Seattle, Washington. After this successful cash exit, Ready started Corvigo, his latest venture, serving as it's president and CEO. Developed the first artificial intelligence and self-learning system for stopping junk email (or "spam"), called Intent-Based Filtering (IBF) technology. Starting Corvigo during the economic doldrums of 2002 (January), Ready led the company to success by doubling revenues every quarter, tightly managing cash-flow, and growing to profitability without raising outside capital. Then, poised for explosive growth with a proven business model behind him, Sequoia Capital, one of the top venture capital firms in the world, chose Corvigo as its only investment in the crowded anti-spam space in 2003.

Ready has been interviewed and quoted in the New York Times, Forbes, Business Week, NPR, Business 2.0, U.S. News and World Report and countless other publications. He was nominated as MIT Technology Review's Top Innovators of 2004 and Corvigo was nominated to Red Herring's Top 100 companies of 2004. He's won the Blue Chip Award from the US Chamber of Commerce, the Ziff Davis Best Technology award, the Rose-Hulman Distinguished Young Alumni Award, and has patented multiple technologies. He sits on board of several technology companies, and is a regular advisor to startups.

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