If you're looking at forming either an LLC or C Corp and plan to raise funding from angel or VC investors, you need to know which is the best option for you.
We posed this question to the Start a Business Hub community of experts to help you figure out the answer.
The general rule seems to be that if you plan to raise funding, a C Corp is a much better option than an LLC for your company formation.
Top expert answer from a business lawyer
The number-one reason that many people are hesitant about incorporating a startup as a C-Corporation instead of as a Limited Liability Company (LLC) is because they’ve heard about the “tax advantages” of LLCs. A C-Corporation pays annual corporate taxes based on its taxable net income, and then if it distributes any money to its shareholders (known as “dividends”), the shareholders themselves are required to pay personal income taxes on the amount they receive.
In contrast, an LLC is effectively invisible (for tax purposes), and “passes through” any net income (without being taxed at the LLC level) to its owners, who then treat it as taxable personal income. Whether or not any money actually passes from the LLC to the individual, the individual owner must pay income tax on their share of the profits (or losses) generated by the LLC. That’s why every year at tax time, every LLC must send every one of its members (and the IRS) a Form K-1, showing their personal share of the company’s profit or loss.
Because of this, word of mouth among first-time founders is that a C-Corporation’s profits are “taxed twice,” compared to an LLC’s profits, which are only taxed once, and should therefore be avoided. Is this true? Yes.
It’s also almost entirely irrelevant for any high-growth startup—because almost none of them will have profits! (Remember that Amazon, today the fourth most valuable company in the world, didn’t show a profit for more than seven years.) Once a high-growth startup begins to generate revenue, it will almost certainly reinvest all of it in the business to fuel more growth, for at least the first several years. No profits to tax means no tax on profits, as well as no dividends paid to shareholders… so no personal tax on those nonexistent profits either. Therefore, for all the worry about double taxation in a high-growth startup, it’s almost always 2 x $0 = $0… or double taxation on nothing!
However, LLCs operating at a loss do offer their owners the ability to pass through some of that loss directly to their personal tax returns, thus reducing their net taxable income. This is genuinely attractive to many startup entrepreneurs, who are likely to be bootstrapping their businesses and forgoing a salary, and are therefore very grateful to reduce their tax burden.
Fortunately, there is a way to secure the same pass-through tax treatment for a C-Corporation, giving a founder the tax benefits of an LLC while still incorporating the “right” way for a high-growth business, and avoiding all the hidden headaches that come with the LLC route (including the difficulty of granting non-founder equity, document customization that results in mandatory legal bills, angry investors demanding their K-1s on time, and the eventual need to convert to a C-Corp). This magical solution is called the Sub-chapter S Election.
S-Corporations: LLC-style taxation on a C-Corporation chassis
The Internal Revenue Code (IRC) provides C-Corporations the option to elect pass-through status: they can simply file Form 2553, which changes the C-Corporation into a “Small Business Corporation,” popularly known as an S-Corporation.
The rules that determine which businesses can elect to be treated as S-Corporations are somewhat restrictive and a little confusing, but in practice end up working for most high-growth startups. To be eligible, a company can’t operate within certain industries, and must have fewer than 100 shareholders (although a married couple or an estate can count as a single shareholder), all of whom are individuals (or “certain trusts” and estates) rather than corporations or partnerships, and all of whom are residents of the United States. In addition, an S-Corporation can only have one class of stock.
This means an S-Corp is perfect for an initially founder-funded startup, and then when your first investors arrive, you simply drop your S-Corporation election and turn into an investor-friendly C-Corp with the ability to issue the Preferred stock that they will insist on purchasing. Also, professional investors often make investments through a corporation or partnership—both of which are deal-breakers for S-Corp status. When the time comes to convert tax status (because the company now has investors or no longer meets the requirements) it reverts back to C-Corporation status, requiring only minor legal, tax, and accounting support.
As neatly as the Sub-chapter S election solves the taxation issue, it turns out that there are actually millions of reasons why a high-growth founder may well want to start out directly as a C-Corp. That’s because…
C-Corps can eliminate taxes on up to ten million dollars of your personal gains!
Under certain circumstances, stock issued by C-Corporations counts as Qualified Small Business Stock (QSBS)—and after five years of ownership, the gains made on the value of this stock can be written off the personal taxes of the stockholder up to $10,000,000 or 10x the stockholder’s adjusted basis in the stock, whichever is greater. That’s right, greater! So the $10M in non-taxable gains is the minimum, provided you have $10M in gains in the first place (which of course you’re going to have, since you’re a high-growth startup, right?).
The kicker? S-Corp stock isn’t eligible for this benefit, and neither is any form of equity in an LLC. This is purely a perk for C-Corporations, and is why every true high-growth entrepreneur—one optimizing for an exit or an IPO, rather than a lifestyle business—chooses the C-Corp approach.
The requirements for equity to qualify for the QSBS exemption are relatively straightforward: stock issued by an active, domestic, C-Corporation that has less than $50,000,000 in assets right after issuing the stock. Virtually all newly-incorporated, high-growth, US C-Corp startups would meet these requirements.
Maybe save a little now, or maybe save a lot later
At the end of the day, this is the question that all startups considering LLC or S-Corp status have to answer: is the possibility of saving a small amount in taxes deducted from your personal income this year worth potentially paying taxes on up to ten million dollars in gains when you make it big?
Let's get some more feedback from the community on whether they think you should choose an LLC or a C Corp for a new business that will raise angel or VC funding.
I agree with the overwhelming consensus – C-Corp! An LLC (or S-Corp) is not going to work for VCs and an increasing number of angel investors for legal reasons.
An LLC is a much less formal and more flexible business structure than C-Corps. Yes, an LLC also avoids a “double-tax” (just taxed once on a personal income tax level), and protects entrepreneurs from personal liability. However, for tax purposes, LLCs are taxed as partnerships, which VCs hate. LLCs are also tough and expensive to convert to C-Corps because the capital structure in an LLC isn’t flexible like it is in a C-Corp, causing angel and VCs to rarely deal with them.
A C-Corp, on the other hand, is the most attractive business entity to angels and VCs. Here’s why:
As every corporation does, it shields entrepreneurs (and investors) from personal liability.
It’s cheaper to set up than an LLC in states that require publication fees for LLC’s
There is a flexible stock structure, making it easy to issue different classes of stock, and for investors to use different financial documents (like convertible notes, SAFES, warrants, subordinated debt)It’s the best structure to raise equity capital through crowdfunding sites like Kickstarter
It allows you to maximize medical coverage tax deduction and minimize employment taxes as shareholder-employees of C-Corps pay FICA (Social Security and Medicare) taxes only on wages they receive
It’s attractive to foreign investors (S-corporations, for example, cannot have any non-resident shareholders). It’s relatively easy for an investor to exit a C-Corp, which is important considering many investors have their end-game in their mind before they even agree to invest
Dividends the C-Corp earns from other corporations are largely non-taxableRaad Ahmed
Angel investors and venture capital firms seek out startups that are organized into C-corporations for three main reasons:
1. Preferred shares
2. Stockholder rules
Investors also like when a company is registered in Delaware. Delaware’s business judicial system allows for business disputes to be cleared up much more quickly. Thus, if you want venture capital financing, incorporating in Delaware might be the best decision for your business. It’s not a coincidence that more than 50 percent of all publicly-traded companies and 64 percent of the Fortune 500 are Delaware entities.Matthew Faustman
So, if you were looking to compare an LLC vs C Corp for angel and VC funding, you now have the answer. Go with the C Corp!