You have a brilliant business idea. And you can see yourself as a millionaire. But sadly, you’re frozen by the very first decision you have to make: Do you form the company as an S corp, C corp, or LLC?
Today’s your lucky day. I’ll make it easy for you. If you plan on growing the business for 5-10 years and then selling it for buckets of money, form it as a C corp. This is particularly true if you don’t expect to be profitable until shortly prior to selling the company, if ever.
“Wait,” you say, “I’ve heard so many great things about S corps.” S corps can save a little employment tax, avoid net investment income tax, and help you take advantage of the 20% qualified business income (QBI) deduction. I won’t deny, there is a place in this world for S corps. I do not give them any serious consideration here because they cannot have entity investors and can only have one class of stock. For purposes of this article, I am assuming you will be seeking financing from investors beyond your circle of friends and family, in which case S corps are generally not an option.
“Wait,” you say again, “I’ve also heard many great things about limited liability companies. If C corporations are so great, why do so many companies choose to form as LLCs?”[1] The primary reasons to form an LLC are typically 1) the avoidance of double-taxation on distributed profits, and 2) the ability of the investors to take flow-through company losses. If the company isn’t planning to pay meaningful distributions but will instead be using any cash flow to fund growth, then reason #1 isn’t compelling.
There are other good things about LLCs. LLCs can issue profits interests, which is the only type of equity in the universe that costs nothing, causes no tax on grant or vesting, and yet starts the capital gains clock. But LLCs are complicated, and the general sentiment that they can easily convert into a C corp or S corp tax-free is not always true as discussed in more detail here. That said, if you continue to be interested in LLCs after reading the below list, call me and we can have that conversation. An LLC may make sense if you have a cash investor interested in taking pass-through losses, or if you intend to run the company as a cash-cow long-term, making annual distributions of profit along the way.
Now without further ado, here’s why I think you should choose a C corp:
1. Simplicity. Set up and accounting costs are usually lower. You can get started quicker and spend more time focusing on your business and less time talking to your tax attorney or accountant.
2. Fundraising. Institutional investors usually prefer C corps. As noted above, entities can’t invest in S corps. Foreign investors generally prefer not to invest in LLCs because such an investment can cause them effectively connected income (ECI). Tax-exempts generally prefer not to invest in LLCs because such an investment can cause them unrelated business taxable income (UBTI). Even if you think it unlikely that a foreigner or tax-exempt would invest in your company directly, the same concern applies if a fund wants to invest but such fund has foreign or tax-exempt limited partners.
3. Employee Equity. If you want to be able to use equity to attract and incentivize employees on a broad scale, this is generally easiest in a C corp. LLCs present several challenges, including the inability to grant incentive stock options (ISOs) and the requirement that employee owners are treated as partners, meaning they receive K-1’s, must pay self-employment tax and quarterly estimated taxes, etc.
4. Tax Returns. In an LLC, every owner generally has to file a tax return in each state in which there is income. Your co-owners won’t love that. If you form as a C corp, while the C corp itself may have to file multiple state tax returns, ownership in your company will not require that the individual owners do.
5. Tax Free Reorgs. When it comes time to sell the company, you may get an attractive offer from a potential buyer, where some or all of the consideration is buyer stock. If that happens, you’ll be glad you chose a C corp because only corporations can take advantage of the “tax-free reorganization” provisions in the tax code, which allow for the deferral of tax in certain transactions where both the buyer and seller are corporations and the consideration is at least 40% buyer stock. It is much more difficult to defer tax on the receipt of buyer stock in a transaction where the target is an LLC.
6. Qualified Small Business Stock. I saved the best for last. What’s better than deferring tax? Paying no tax. This is where C corps blow LLCs and S corps out of the water. If your business is going to be a non-service business and otherwise meets the requirements explained here, and if you hold the stock for more than 5 years, when you sell it, you will have zero (i.e., $0) federal tax. And as long as you don’t happen to live in California, you will likely also have zero state tax.
I know C corps aren’t perfect. For example, when you are selling the company, if the deal is structured as an asset sale, being a C corp can cause a second layer of tax that wouldn’t have existed had you been able to remain a pass-through entity until an exit. So do consider the pros and cons, but don’t let analysis paralysis keep you from picking a path and making your business idea a reality!
Mike Baker frequently advises regarding choice of entity. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
Special thanks to Evan Kastner for his help with this article!
[1] For purposes of this article, when I refer to an LLC, I mean a limited liability company taxed as a partnership.