Why do startups choose to incorporate as C-corporation over LLC?

by Adarsh Raj Bhatt in

The general opinion is that venture-capital-seeking startups should shape up as C-Corporations rather than LLCs. 

Given this prevailing opinion, it’s surprising to know that an LLC is an extremely customizable structure that can be used to create frameworks that are identical to those of a C-Corp. An LLC can establish membership interests that are similar to corporate shares, such as separate levels of ownership and customizable rights, and it can also choose to be regulated as a C-Corp. 

That’s not all…

Since there are fewer called-for formalities, an LLC is usually easier to set up and manage (with the caveat that more customization entails more work). 

The question is: 

Why don't more emerging growth enterprises use LLCs, given their flexibility? Why do most startups prefer to incorporate as C-Corps? What is the difference between a C-Corporation and an LLC, and how does it all even work? 

We dive deep into these questions and many more.

TLDR

  • The short response is that startups tend to prefer incorporation since investors favor C-corporations for various reasons that include tax ramifications, minimal restrictions on the number of shareholders, the ability to grant different stock classes, and a few other important factors.
  • For certain eligible small businesses, C-Corp offers limited liability, ease-of-use and setup, the right to grant stock options, and tax incentives upon sale.
  • Venture-backed startups that have already emerged as LLCs can consider transitioning to C-Corps in view of investor priorities and the pragmatic ease of operation under pre-established C-Corp conventions. 
  • Your accounting department or your lawyer could help you better assess if incorporating is a good fit for the specific case of your company and your growth strategies.

What are C-Corps?

A C-corporation (or C-corp) is a corporate legal framework in which the shareholders or the founders are taxed separately from the organization. C corporations, which are the most common form of corporation, are also taxed on their corporate income. Profits from the business are taxed at both the corporate and individual levels, resulting in a double taxation scenario. 

It can have a limitless number of owners and several stock classes. These features and other benefits make it the right platform for enticing venture funding and several other kinds of equity financing.

What are LLC’s? 

An LLC or a Limited Liability Company is a type of private limited company that is exclusive to the United States. It's a corporate arrangement that blends a partnership or sole proprietorship's pass-through taxation with a company’s limited liability. 

S corporations and limited liability companies (LLCs), for example, are similar to C-Corps in that they distinguish a company's assets from those of its shareholders, but they have different legal arrangements and tax affairs.

How do C-Corps work?

A C-corporation (abbreviated as C-corp) is an arrangement often used by bigger businesses or other entities that are looking for investment. 

Many founders who want to form a C-corporation do so because it is expected of them - for example, if they have more than 100 shareholders. Others, such as those who own high-growth startups, prefer a C-corp system to lure buyers. A C-corporation's biggest disadvantage is that it is charged tax twice: once at the corporate level (21%) and once at the individual level. 

One of the most common motives for incorporating a business as a C-corp is to draw investors such as Venture Capitalists or Angels. C-corporations are favored by such shareholders for a number of reasons, such as the opportunity to sell preferred shares and make an initial public offering (IPO) if the company succeeds. This is to circumvent shareholder restrictions and to exercise power over shareholder voting rights. 

The majority of publicly traded companies are C-corps, and have no limitations on the number of shareholders they may have. While an LLC doesn’t have such a limitation of the number of shareholders, there is a restriction on the kinds of entities that can become shareholders. For instance, in many states, entities like banks and insurance companies are not permitted to form LLC’s. No restriction of such a kind applies to shareholders in a C-Corp. Moreover, C-corps have the option to sell common stock with less voting rights than those of other shareholders.

C-Corps also incorporate other features that are not present in the case of LLC’s. These are discussed under “Advantages of C-Corporations”.

How do LLCs Work?

                     

A limited liability company (LLC) is a hybrid corporate arrangement that combines the stability, convenience, and tax benefits of a collaboration with the liability protection of a corporation. 

A limited liability company (LLC) may have one or more “members”, which is the formal term for the owners. Individuals or other enterprises could be members, and the number of members of an LLC is unlimited. The personal assets of members are shielded from the business' creditors under an LLC structure. An LLC does not need to hold annual member meetings or record minutes of the meetings in most states.

The members of the LLC make most of the important strategic decisions, while the executives run the operations on a day-to-day basis. All business property is maintained under the LLC's name. Even the franchise would be under the name of the LLC if you decided to set up a franchised company. 

C-Corps versus LLCs

   

Starting out as a C-corporation (commonly in Delaware) makes the most sense if you choose to pursue the conventional “startup route” of raising funds, issuing equity compensation rewards, and expanding the company as soon as possible to achieve an exit. 

The $10 million tax deduction for qualifying small business shares owned for at least 5 years, which applies only to C-corporations and not to LLCs, dramatically increases the advantages of following the traditional C-Corp approach. 

But there’s a catch.

If you don't want to establish a corporation only to sell it, and you don't want to be pressured by shareholders or investors to provide liquidity for them, LLCs are a viable option. 

Since there is only one tax layer for an LLC, it is cheaper to distribute cash on a constant basis than it is for a C-corporation. In the corporation format, this is more difficult to achieve because C-corporations incur taxes - so that their investors have to pay taxes as the capital is distributed. This is known as the “C-Corp double tax”.

What this means is that after paying corporate income tax on its income, a C-Corp pays out dividends to shareholders. The corporate income tax is the first tax layer. After dividends are paid, shareholders file their personal (income) taxes on the received dividends. And that’s the second layer of taxation. 

Together, these two layers form the dreaded “C-Corp double tax”.

However, a major limitation of LLCs is that they lack the authority to issue shares, which are a common equity compensation format that startups provide to employees and investors, effectively reflecting the ability to buy shares in the company at a discounted rate anytime it is beneficial to do so.

Since practically any profitable high-growth business would need external funding, these frameworks (pertaining to division/distribution of ownership) would need to be turned into analogous C-Corporation ownership units (i.e. shares).

Advantages of C-Corporations

             

#1: Benefits of Qualified Small Business Stock

Qualified small business stock” can be issued by C-corporations. LLCs are unable to issue stock to eligible small businesses. 

What are the advantages of owning “qualified small business stock”? You will exclude up to $10 million from federal taxes, plus the alternative minimum tax, if you bought shares after September 27, 2010, and held them for five years. If you haven't completed the 5-year holding limit, you might be eligible for a rollover under Section 1045. You could save $2.38 million in federal income tax on the selling of your business if you apply for the Section 1202 QSBS benefit

A C-corporation must fulfill a variety of criteria in order to issue authorized small stock, but the QSBS (Qualified Small Business Stock) benefit tends to be readily available in most cases. 

#2: Conventional Angel and Venture Capital Investments Can Be Made More Easily

Key investments (including angel and venture capital transactions) are usually made by the issuing of convertible preferred shares by C-corporations. 

Many LLC laws allow members to negotiate what they desire in their LLC Agreement, including the waiver of fiduciary duty. This means that before making any investment, any LLC arrangement must be closely checked. LLCs are disliked by some investors. In fact, foreign investors in LLCs may find themselves unexpectedly required to file tax returns in the United States. 

Such problems do not occur in C-corporations, where conventional angel and VC investments can be made with relative smoothness.

#3: Ability to Engage in Tax-Free Reorganizations and the Availability of Traditional Equity Compensation

Standard stock options and "incentive stock options" can be issued by C-corporations. 

It's far more difficult for LLCs to offer their workers any alternatives to stock options. Profit interest is the most common type of LLC equity grant award, but this necessitates intricate capital account maintenance work that you won't find in a C-corp. LLCs are also ineligible for "incentive stock options”. Moreover, each LLC participant may be expected to file a tax return in more than one state if he/she resides or operates in multiple states.

For C-corporations, however, it’s not as cumbersome. Because C-corporations are not pass-through entities, their investors would generally not have to think about suddenly having to file tax statements in new states.

#4: Lesser Overall Complexity/Uncertainty

LLCs embody greater overall complexity (than C-corps) due to their potential flexibility. 

The taxation of partnerships is also significantly more complicated than the taxation of C-corporations. Because of the LLC's comparative newness, as well as the limited amount of its case law and legal history that has evolved in comparison to corporate documents, LLC dealings can get trickier and more unpredictable than corporate transactions.

Thus, C-Corps have lesser overall complexity than LLCs.

#5: The Absent Burden of Self-Employment Taxes

The income of a C-corporation's shareholder is not subjected to self-employment taxation. Self-employment tax is a government tax imposed on the income of self-employed people. However, it is not the same as federal income tax.

Is the grass just as green on the LLC side? No. 

On their distributive share of ordinary trading and company profits, LLC members are normally entitled to self-employment taxes.

Advantages of LLCs

#1: Single Level of Tax

LLCs are pass-through bodies, meaning that their proceeds (or revenue) are taxed only once, at the member level (up to 37% plus state income tax if applicable). 

On the other hand, the revenue of a C-corporation is taxed (at a rate of 21%) - and all “dividend” transfers of shares and gains to stakeholders that have already been taxed at the C corporation level are also taxable (to the shareholders), sometimes at a rate as high as 23.8%.

#2: Favourable Sale of Assets

Buyers of companies tend to prefer a basis step-up in the properties of the company that they are purchasing. While this may be possible in the case of an LLC, it is impossible to achieve the same in a C-corporation setup without triggering a second layer of tax. 

As a matter of fact, this might be among the most common concerns or grievances about C-corporations.

#3: Tax-Free Distributions of Appreciated Property

An LLC could distribute appreciated assets to its stakeholders without the LLC or its members obtaining any recognition, thus allowing for spin-off transactions without incurring significant taxes. 

In contrast, the distribution of appreciated property by a C-corporation to its stakeholders is subject to corporate taxes as well as potential shareholder-level taxation.

Limitations of C-Corps

#1. Double Taxation

Since profits are taxed both at the business level and again at the shareholder dividend level, double taxation is unavoidable in the case of C-corps.

#2: Expenses that Accompany C-Corps

The registration of the Articles of Incorporation comes with several expenses. Corporations also have to pay taxes to the states in which they do business.

#3: Formalities and Government Scrutiny

Owing to complicated tax regulations and the immunity given to shareholders against being held liable for lawsuits, debts, and other contractual commitments, C corporations are subject to greater federal scrutiny than other business structures.

Limitations of LLCs    

     #1: The Limits of Limited Liability

A judge may rule in court that your LLC arrangement does not cover your personal assets. The action is considered as "piercing the corporate veil" because it will put you at risk:

  • If you don't explicitly distinguish company and personal transactions, or 
  • If you've been found to have handled the business unlawfully, causing losses to others

#2: Self-Employment Tax

If the LLC is taxed as a partnership, employees who work for the company are considered self-employed by the government. 

This assumes that such members are individually liable for paying Social Security and Medicare taxes, which are dependent on the company's gross net profits and are collectively known as self-employment tax.

#3: The Aftermath of Member Turnover

In certain states, if one of the members leaves the business, declares bankruptcy, or dies, the LLC must be dismantled, and the other members become responsible for all remaining legal and financial obligations. These members can obviously continue to do business - they'll just have to establish a new LLC from the scratch.

Why do startups choose to incorporate as C-Corporation over LLC?

Most startups choose to incorporate as C-Corps. 

Only a few startups form LLCs at first and then transition to a C-Corp when the time comes. The reason why this is not a popular course of action is that there are issues that occur in the wake of incorporation. These include issues like:

  • The new corporation would need to obtain a new Federal Employer Identification Number (FEIN) and will have no credit history.z
  • Adjustments would need to be made to the bank, web pages, insurance plans, and so on, to now identify the LLC as a corporation. Depending on the LLC's history, all of these steps could take a long time.
  • If there are pending payables or debts on the financial statements that are assumed by the organization, the LLC's owners will be credited revenue from the LLC's debt forgiveness which will be subject to ordinary income tax rates.

Here are three big reasons why most startups choose to incorporate as C-Corps:

#1: Protection from Legal Liability

Incorporation excludes you, the founder, as a private individual from the equation and replaces you with a new human-like entity that can carry out all of the same functions but is legally distinct.

This body, the corporation, can do pretty much everything you can, including signing contracts, buying things, and selling them. The only difference is that you will not be directly responsible for any debts incurred if anything goes wrong, such as the organization going bankrupt.

In this manner, incorporation offers you protection from legal liability.

#2: Seamless Division of Ownership

The capacity to distribute ownership of your business is the second major advantage of incorporation. 

To keep the system as transparent and equitable as possible, you'll want to formalize who owns what, like splitting co-founder equity, as soon as possible. This is a relatively straightforward and well-understood method for C-Corporations via stock issuance - but it attains a painful level of complexity for LLCs.

Additionally, many angel investors and venture capitalists would also prefer that the startup be a Delaware C-Corporation for legal purposes, and if it isn't, you might have to consider transitioning to a C-Corp, making for a costly and time-consuming procedure. Beginning with your shares split and an organizational structure oriented for future investment would save you time, money, and cognitive load in the long run.

#3: Ensuring that important IP stays with the company

This section is particularly important for high-growth startups that are primarily concerned with designing innovative new technology or techniques.

Intellectual property, which includes everything from legitimate ownership of the brand name to trademarks to the software that powers the app, is at the core of all such innovation-centric startups.

You will want the intellectual property assets to be the property of the startup - not the individual founders. In a C-corporation arrangement, the founder’s individual contributions will remain with the company even if they leave. 

This has 2 big advantages: one, the company’s future won't be held hostage solely on the basis of someone's past contribution; and two, it provides a reasonable justification for each contributor’s equity stake. 

Besides, there is also a financial advantage to ensuring that IP stays with the company. The intellectual property's value can be considered to be part of the company's value, which is the primary mechanism that investors use to figure out how much funding to put into a startup. 

In which cases are LLCs preferred?

LLCs are preferred in the case of companies that:

  • Do not intend to attract external investors. They can benefit from LLC tax protection.
  • Wish to organize their company and ownership structures creatively. They can capitalize on the LLC’s flexibility. 
  • Wish to avoid corporate income tax and adhere to a single layer of tax.

If any (or all) of the aforementioned points are true in the case of your company, then it’s worth exploring the possibility of going the LLC route. 

Need any help?

At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so that you can focus on what matters most.

If you're looking for help on deciding whether to incorporate as a C-Corp or form an LLC, drop us a note at hello@abstractops.com. Let’s talk!

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