Some institutional investors, and many investment firms, cannot invest in startups that were organized as LLCs or partnerships due to their own investors. If an investment firms accepts investment from tax-exempt investors (e.g., pension funds, individual retirement accounts, foundations, and endowments), which account for a large portion of institutional investment, or, international investors, they typically cannot invest in LLCs or partnerships.
In the case of tax-exempt investors, they want to avoid "active trade or business" income that could jeopardize their tax exemption. For international investors, they want to avoid "effectively connected income" derived from a US trade or business that could subject them to US filing requirements.
In both instances, ownership of an LLC would typically trigger such concerns, whereas ownership of shares in a corporation would not. As many institutional investors have significant international and/or tax-exempt investors who typically cannot invest in LLCs , if your company plans to attract institutional investment, a corporation is typically a better choice of entity.
Increased state tax filing requirements
By default, LLCs are taxed as partnerships, meaning an LLC's taxable income is passed directly to its members, who then pay taxes on that income based upon their percentage ownership (reported on an annual K-1). If the business operates in multiple states, its members often have tax filing obligations in each of the states the partnership does.
In contrast, shareholders in a corporation typically only pay taxes in one state, based upon their dividend distributions or the sale of the stock. Some investors just don't want the added tax complexity involved with filing state tax returns all over the country.
LLCs require drafting complicated agreements
One of the advantages of an LLC is its flexibility, however, with added flexibility comes added complexity. LLCs are largely creatures of contract. While there are many statutory requirements, the members of an LLC have considerable freedom when drafting an LLC's operating agreement (called a "company agreement" in Texas).
An operating agreement typically covers the following:
* Rights, powers, and entitlements of members and managers
* Transfer restrictions
* Distribution of profit
* Allocated tax responsibility
* Capital accounts
* Capital structure
* Future capital contribution requirements
* Other complex issues.
As a result, a well drafted operating agreement is often, quite complex, long, and difficult to negotiate, draft, review, and agree upon.
In contrast, while a corporation's organizational documents can certainly be complicated in some circumstances, they are generally much easier to prepare and work with. The articles of incorporation (called a "certificate of formation" in Texas) are often quite simple, mostly detailing the capital structure of the corporation (sometimes in conjunction with a certificate of designation) and designating a registered agent.
Corporate bylaws are also quite simple in contrast to an operating agreement. They generally cover:
* Election of officers and directors
* Shareholder meetings
* General information about the corporation
These documents are often fairly standard, and lack the complicated features of an operating agreement (such as tax allocation). Many investors, including institutional investors, are familiar and with the organizational documents of a corporation, and are more comfortable with the simplicity of stock ownership.
LLCs complicate and limit equity compensation options
Quality management and employees are key to the growth and success of a startup. However, cash for high salaries usually doesn't exist.
As such, equity compensation is vital for a startup to attract, retain, and properly motivate its employees. Equity compensation for LLCs and partnerships can be incredibly complex. While there are a variety of equity compensation options available to LLC's, they tend to involve complicated tax issues that often cause them to be both complicated and expensive.
Corporations, on the other hand, have a host of relatively straight forward equity compensation options to pick from when compensating key employees.
Potential disadvantages of a corporation
The biggest, and most obvious disadvantage to a corporation is that it has two levels of taxation, whereas an LLC has one. A corporation pays corporate taxes on taxable income it generates at the corporate level, and afterwards, the shareholder pays taxes on dividends it receives distributed to them as dividends. This feature of corporations is often why business owners elect to use an LLC or partnership, or alternatively decide to make an election with the IRS to be treated as an S-corporation.
However, it should be noted that dividends are typically taxed at favorable capital gains rates rather than as ordinary income, but the additional layer of tax can often result in a higher effective tax rate. For many businesses, an LLC's single level of tax makes it the better choice of entity, particularly if the business holds property, such as real estate that is expected to appreciate in value.
Yet for many entrepreneurs, their goals for a startup involve, raising capital, investing that capital in the company, using equity compensation to attract key employees, rapidly growing the company, and ultimately exiting by selling the company or going public. For businesses with these types of ambitions, the corporation is typically preferable to an LLC for the reasons described above.
Consider starting with an S-corp instead
Another benefit to organizing your startup as a corporation instead of an LLC, is that you can obtain some of the benefits of a corporation described above, while also enjoying a single level of taxation, by making an S-election. An S-corporation is taxed is similarly to, but not identically to, an LLCs. However, unlike LLCs, S-corporations often permit reducing self-employment taxes through careful tax planning.
The tax treatment of the S-corporation is popular with business owners, however, this does not come without certain costs. To make a valid S election, ownership is restricted to no more than 100 shareholders, none of whom may be foreign or organized as entities (with certain exceptions). In addition, an S-corporation may only issue one class of stock, preventing use of shares other than common stock.
Regardless, if the business later decides it would no longer be taxed as an S-corporation or comply with their specific requirements, its easy to switch back to a regular corporation by merely terminating their S-election with the IRS. For this reason, if you are on the fence of whether or not to organize your business as an LLC or an S-corporation, its often prudent to organize an S-corporation due to your ability to easily convert to a regular corporation.
However, I don't want to leave you with the impression in this post that corporations are better for startups than LLCs , or any business for that matter. Instead, I want to point out that despite the popularity of LLCs, they aren't always the best choice of entity.
Each business has its own specific set of circumstance, goals, and needs that need to be carefully contemplated when determining what type of entity is best for your business. Due to the complexities involved in selecting the best entity type for your business, it's always best to contact an attorney to help you make these decisions and organize your business.
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