Should I form my startup as an LLC or a C corporation?

In most cases, if you’re an entrepreneur planning to raise outside capital from investors, you’re going to be advised to structure your company as a C corp. It’s not unheard of for a venture capital backed startup to be an LLC, but it’s not common.

LLCs can be created with membership interests, which is the LLCs parallel to shares, and membership interests can have different classes with different voting rights. LLCs are generally simpler to form. They’re a fairly flexible entity to use. For example, you could create an LLC, write an operating agreement that classifies the members into different classes (like the stock you’d have in a C corp) and decide how each class can and can’t vote. So why do startups rarely choose them?

Short answer is that investors really, really prefer C corps for a number of reasons. This is mostly about tax issues, but also includes a few other factors.

The Tax Treatment

The big reason investors prefer C corps is the tax treatment. This tax issue is the part investors will definitely talk to you about when you discuss your choice of entity. Consider carefully before setting up your startup as an LLC if you want it to raise money from VCs someday. It’s possible, but it’s probably going to be tough.

The Qualified Small Business Stock (QSBS) rule is probably the biggest tax perk of investing in C corps. Some startups dissolve into a new C corp in Delaware to qualify for QSBS treatment.

In order for Section 1202 treatment to apply, the stock has to be purchased when the company is worth less than $50 million. Seed rounds are typically done at a valuation around $5-10 million, so most startups are eligible.

You have to keep QSBS stock for at least five years to make it work. Then, if you sell for a gain, you can exclude 50% or even 100% of the gain from your taxable income. You can also reinvest the money in another startup that is also QSBS stock, deferring the tax.

There is another tax issue: some venture capital funds have nonprofit LPs like pension funds or university endowments. In that case, having the LP invest in an LLC could create unrelated business taxable income (UBTI) that threatens the LP’s exempt status. A special purpose entity can fix this, at some additional expense. It’s just another layer that adds cost.

Harder for Investors to Diligence Them

One of the things that’s cool about LLCs is that you can customize them pretty much any way you want to. The flipside is that the operating agreement can really have any provision at all. For a big round, your investors have to read it all to figure out what they’re buying.

The other challenge with LLCs is that C corps have a standard way of issuing several classes of shares. VCs want startups to be a C corp rather than an LLC because you can more easily get the standard features they need when issuing stock, namely preferred stock that has liquidation preferences, board seats, pro rata rights, etc.

LLCs do not issue shares. They grant units of the LLC. So the units can be built with the kinds of rights that preferred stock has, but there is no standard template for the rights. This means there is a lot more complexity and cost in creating the rights that VCs are expecting to see in a startup that’s an LLC rather than a C corp.

The thing about LLCs is that investors aren’t necessarily familiar with them. If a startup is going to be an LLC, they have to work harder to figure out exactly what will and won’t work. There’s a lot less legal precedent with LLCs, so there is much less certainty about what will stick if you have a dispute.

A startup’s founders tend to think only about their own legal fees. In a financing, the startup will probably end up paying the investors’ legal fees. The legal bills are likely going to be a lot higher for an LLC. This is a hidden cost that some founders will have to take on when doing this financing.

Pass-through Taxation of LLCs

LLC owners tend to tell startup founders, “Hey I have an LLC, the profits flow through to my taxes, it’s way better than a C corp, no double taxation!” It’s like a sole proprietorship. With a C corp, profits get taxed at the corporate level, and your salary can get taxed again. With an LLC, you avoid double taxation.

The problem is that most startups don’t turn a profit for at least 2-3 years. Corporate taxes are paid on profits. That’s one of the nice things about a C corp- if it doesn’t make a profit, it doesn’t pay double tax.

During those early years, you’re probably going to pay yourself little or no money at all. Until there’s revenue (and sometimes VC money), there’s often no salary for anybody. You’re definitely not going to be generating any kind of wage that’s going to pay a lot of personal taxes.

In addition to the tax break for investors, the QSBS rule also covers founders’ own stock. After holding them for 5 years or more, startup founders may exclude up to $10 million of gain on sale from being taxed. Great for founders.

So before you commit to an LLC, understand that your choice of entity can result in millions of dollars more in personal income taxes down the road. QSBS applies to US taxpayers who buy shares in a C corp early-stage tech startup.

Early-stage startup employees are often offered hefty slabs of stock options to attract and retain them. Paying a high salary might not be possible at the moment, but a valuable piece of equity can help hang on to good people for the long run.

One reason startups choose to be a C corp is because it’s simpler for them to grant stock options to key employees. It’s much harder to do this in an LLC.

A quick recap: Why you won’t usually choose to have a startup be an LLC comes down to taxes, whether you plan to raise VC in the future, and how easily you’ll be able to issue shares.

First, C corps are almost always used by startups that plan on taking venture capital (VC) money.

Second, the tax breaks for investors are very attractive.

You have more diligence expenses when starting up as an LLC and it will close slower.

There’s also pass-through taxation of LLCs, but in the first few years, founders rarely benefit from it.

Most new companies don’t make a profit in their first few years. C corps might owe taxes, but unless they’re profitable, they won’t owe much, sometimes none.

If the shares qualified as QSBS (Qualified Small Business Stock) when you acquired them, you may pay zero federal income tax after selling them.