This is a guest blog by Mark Oblad, founder and principal developer of Valcu
So you’ve got your great business idea and you’re ready to get started. Or, maybe you’ve gotten started and you want to make it official. You’ve decided you need an entity. But what kind?
You’ve heard that you should just start with an LLC and that it’s easier. Maybe you’ve heard that you should definitely do Delaware. Or, maybe the opposite, don’t waste your money by paying franchise taxes in two states.
In some cases, the answers may be clear, but in many others, it’s not.
Pass Through vs. Double Taxation
As a baseline, tax rules in the U.S. distinguish between entities that are considered pass through (or disregarded in some cases): entities that don’t pay their own layer of income tax; and entities that are taxable: entities that pay taxes on their own income.
Generally speaking, pass-through entities will still have to keep full records and file tax returns, but rather than paying income taxes, the entity tells all of its partners or members what their share of the income is. The partners and members are then responsible for reporting their share of the income and paying taxes. These taxes would be owed whether or not the entity made a distribution to its partners or members.
Entities that are subject to two levels of taxes have full responsibility for reporting and paying income taxes. The second layer of tax comes in when the shareholders of the entity get money back from the entity, either as a distribution of excess cash (a dividend) or when the shareholder sells its shares, and pays taxes on the dividend or sale of shares.
With a pass-through entity, while required book “allocations” of income to the entity’s partners or members are taxable events, “distributions” to partners or members are generally not taxable events. Furthermore, partners or members of pass-through entities may be able to offset other income with losses generated by the entity, subject to passive-activity loss, at-risk and other rules.
Limitations on Pass-Through Entities
So, less tax is better. Why not just be a pass through?
In businesses where it is likely that frequent distributions will be made to its partners or members (e.g., consulting and other service-type businesses, businesses earning royalties, etc.), the pass-through entity choice makes a lot of sense.
In some cases, however, restrictions are put on pass-through entities in order to level the business playing field. For example, consider non-profits. If the pass-through entity doesn’t pay any taxes, and its partners or members are also exempt from tax then no taxes would paid on the pass through-entity's business activities at all. This would also mean that non-profits would be able to fund businesses that could operate at cut-rate prices and unfairly compete against taxable businesses without the same advantage. Consequently, non-profit entities have to pay penalty taxes if they generate business income (unrelated taxable business income, or UBTI).
What does this have to do with your business? If you are seeking investment from venture funds or other equity investors who have tax-exempt partners or members, you will likely have to become an entity that is double taxed. Many of the venture funds are pass-through entities all the way up to their limited partners, some of whom are non-profits. As such, the venture funds operate under a number of governance rules designed to limit the possibility of generating UBTI. In broad strokes, venture funds are unwilling to invest in pass-through entities that are operating businesses, in order to ensure that any non-profit partners or members do not generate UBTI.
Corporation vs. S-Corporation vs. LLC
By default, corporations are double-taxed entities (the C-corp). In some cases, tax rules allow a corporation to file an S-election to become a pass-through entity. The upsides of the S-corporation are pass-through status (though some states and other taxing authorities (e.g., Massachusetts and New York City) may not afford the (full) benefits of pass-through status to S-corporations) while at the same time enjoying the strong support network around corporations. S-corporations may be easy to get back to C-corporations a well: just fail the rules, by for example taking an investment from, and issuing preferred stock to, an entity.
S-corporations, however, operate under a number of limitations. Some of the principal limitations are: (1) they may only have one class of stock; (2) only individuals and certain trusts may own shares; (3) only U.S. citizens and tax residents may own stock; and (4) they may have no more than 100 shareholders.
Getting in on the game of offering corporate flexibility and limited liability on an entity type that would be considered a pass through, states created the limited liability company (LLC). The downsides of the LLC are that most venture funds will require the entity to convert to a corporation or will have to set up its own corporation to sit in between the venture fund and the LLC. Conversion to a corporation can also be complicated--often done as a merger of the LLC into a corporation, in which LLC interests are exchanged for different series of stock that replicate the differing investments made in the LLC. Members of an LLC may also be required to file tax returns and pay taxes in additional states, and non-U.S. members of an LLC may be required to file tax returns and pay taxes in the U.S.
Despite its double-taxed status, the basic C-corporation may be the end goal in many cases. One possibility for mitigating (or deferring) tax in a C-corporation is when the corporation’s stock qualifies as “qualified small business” (QSB) stock. There are a number of requirements to obtain these benefits, including a 5-year holding period and/or reinvestment into another QSB within sixty-days.
On the downsides of a C-corporation, if there is a reason to convert the entity to an LLC, there may be a large tax bill as a result of such conversion. Furthermore, if the company exits through a sale of assets (more often occurring during a fire-sale of the company) rather than a merger or stock sale, the full brunt of double taxation will likely be borne: the entity realizes gains and has to pay taxes on the sale of assets, and the remaining proceeds dividended out to shareholders are subject to dividend tax.
States charge franchise taxes on entities created in their state and benefit from having as many entities as possible paying these taxes. This also means that states compete against each other for franchise tax, by among other things adopting laws meant to foster business, investing in a sophisticated court system that interprets corporate rules and investing in the administrative arm that processes filings for the entities. The state that has fared best in this game is Delaware. There is also a snowball effect where case law becomes the most developed, law students studying corporate law nationwide focus on Delaware law and large law firms nationwide maintain their forms to accommodate Delaware law.
Every time a company touches a new jurisdiction, there is a new possibility for tax leakage, or the obligation to pay taxes in that jurisdiction. If you’re in another U.S. state, your business will likely also have to qualify to do business and pay annual qualification taxes locally in addition to Delaware. For some small businesses with competent advisors who have ready-built forms around local law, it may make sense to save on the franchise taxes. Furthermore, if you and your business are not in the U.S. and are aimed at a non-U.S. market, subjecting your company (or yourself) to taxes in the U.S. may not be a great idea in the long run. The possibilities for venture financing in the U.S. may, however, counterbalance this consideration.
Some Common Myths
Myth: LLCs are easier. Truth: LLC documents tend to be less standardized. LLCs with more than one member generally must also file tax returns and distribute K-1s to their partners or members. Single-member LLCs (disregarded entities) may also be subject to additional IRS scrutiny. The Delaware franchise tax may be lower for a Delaware LLC, but in states like New York, the (Delaware or other) LLC is hit with $2k publication requirement.
Myth: LLC-to-corporation conversions are easy. Truth: simple tax reclassifications (e.g., form 8832) may cause a capital shift and don’t change the corporate law. Merging an LLC into a corporation can allow for a matching of the capital accounts while avoiding triggering most assignment clauses in contracts.
Myth: Incorporating in a low (income) tax jurisdiction will save taxes. Truth: many jurisdictions will look at where the business is operating in addition to the place of incorporation to determine taxability.
Myth: LLCs don’t have shares and don’t have option plans. Truth: the LLC is very flexible and limited liability company agreements can be written to mimic corporations with shares and multiple classes (though these LLC agreements can be complicated). LLCs can also adopt option plans (though options granted through the plan would not be treated as Incentive Stock Options (ISOs)). Note that profits interests granted through, or the exercise of options under, such an option plan, can make the holder a member of the LLC, and consequently reclassify the holder from a W-2 employee to a K-1 partner.
Myth: C-corporations and S-corporations are incorporated differently. Truth: C-corporations and S-corporations generally start out as a basic corporation and are treated differently by tax rules when they make tax elections.
If the plan is to build a fast growing company that is using any cash generated to fuel growth and will likely raise venture funding, a Delaware corporation may be the best fit. Holding companies and cash-generating companies usually fit well in a Delaware LLC. Businesses with less clarity may have a more difficult cost-benefit analysis.
FOR A NUMBER OF REASONS, THIS POST IS NO SUBSTITUTE FOR, AND IS NOT AND SHOULD NOT BE CONSTRUED AS, LEGAL OR TAX ADVICE.
Many thanks to Nicholas J. Guttilla from Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP, James “Jace” Clegg from Ropes & Gray LLP and Jeanne Goulet from Marks Paneth LLP for helpful discussions and pointers.
Mark Oblad is the founder and principal developer of Valcu Inc. (valcu.co). Mark cut his teeth at Gunderson Dettmer, picked up the CFA designation on the weekends and attended law school at UVa. Valcu provides automated tools for incorporating startups in Delaware and running the post-incorporation setup (appoint directors and officers, adopt bylaws, issue founder stock with vesting and generate founder consulting or employment agreements with IP assignment). Valcu also has a number of other web tools under development to help professionals and startups, including capitalization table maintenance tools, term sheet and financing document generators (accommodating the full deep structure of the documents) and valuation tools.