In my last post, I discussed why most high-growth, venture-backed startups elect to do business as C Corporations. In this post, I focus on the unique benefits offered by LLCs and when a startup may opt for an LLC over a C Corporation.
Ability to Offset Startup Losses Against Other Income
As discussed in a prior post, LLCs by default are taxed as either partnerships (for LLCs with more than one owner) or a disregarded entity (for LLCs with a single owner). However, an LLC can elect to be treated as a C Corporation or S Corporation for tax purposes. With an S Corporation election (as with a partnership or a disregarded entity), the profits and losses of the LLC flow through to the owners of the LLC and are reported on the owners’ individual tax returns. While investors typically disfavor this flow-through tax treatment, it offers a major benefit to founders in certain situations. This is particularly true for founders of a business generating losses in the early years if the founders have other sources of income. If, for example, (1) the founder is working on his or her startup on the side and has income from their primary job, or (2) the founder’s spouse has income from his or her job, flow-through losses generated by the LLC may, in certain circumstances, be used to offset that income to lower the founder’s personal tax liability.
Simplicity and Flexibility of LLCs Relative to C Corporations
LLCs also offer two characteristics not typically attributed to corporations: flexibility and simplicity. The management structure of corporations is driven by statute, with the rights and duties of the Corporation’s shareholders, board of directors, and officers largely set by law. LLC owners, by contrast, have near unlimited flexibility to allocate economic and management rights however they choose. While I view the flexibility offered by LLCs as a positive, founders should use this flexibility cautiously. Going overboard with overly unique deal terms requires more time and expense on the legal side to ensure that the deal is memorialized in the company’s LLC Operating Agreement. I will explore the terms of LLC Operating Agreements in a future post.
Second, LLCs are generally simpler to maintain than corporations. Corporations, for example, are required by statute to hold regular meetings of the board of directors and to maintain certain records applicable to the corporation’s business. Conversely, none of these requirements are imposed on LLCs by statute, freeing up a founder to focus on running their business. While LLCs often mimic the corporate structure by establishing a board of directors (typically called a board of managers in the LLC context) and appointing officers, this is not required by statute, and there is no obligation that the LLC hold regular board meetings or maintain records to the same degree as required of corporations.
When to Opt for an LLC over a C Corporation
While each situation is unique, I typically see founders opt for an LLC in a few specific situations. The first is described above and involves a founder starting a business on the side when (1) the startup will generate near term losses for things such as R&D or other material startup costs specific to the business; and (2) the startup’s losses can be used to offset significant income of the founder and/or their spouse. In this situation, the tax benefits drive the decision to use an LLC over a C Corporation.
The second situation is a founder who may have been operating the business informally (potentially without a legal entity), who reaches an inflection point making a legal entity a necessity. Typically, this occurs when the founder needs to sign a contract with a third party, such as to provide a product or service or to hire an employee or contractor. An LLC would be a great choice in this situation, as it can be formed very quickly and inexpensively. Further, if the business is owned by one founder, all management and economic rights would likely remain with the founder anyways, making a C Corporation unnecessarily complicated at this stage. Down the road, the founder could always convert the LLC to a C Corporation if necessary (such as in connection with raising a round of venture financing), but at this stage the simplicity of an LLC likely makes sense.
Lastly, an LLC with pass through tax treatment likely makes more sense than a C Corporation when the business plans to regularly distribute out profits to its owners in lieu of reinvesting those profits to speed up growth. Recall that C Corporations are subject to double taxation—once at the corporate level and again at the shareholder level when profits are distributed. LLCs taxed as disregarded entities, partnerships or S Corporations are subject to a single level of tax, making this a more tax efficient structure than a C Corporation in the above scenario.