When first beginning a company, many startup owners think that setting up the company as a Limited Liability Company (LLC) is the best option for the company's structure. They believe that an LLC offers the owners protection from the company's debts and liabilities similar to a corporation. And at the same time, the LLCs' “pass-through” nature, distributing profits to partners, means that the startup's founders can avoid the “double-tax” from corporate and individual filings.
While this is partially true, if you're doing a cost-benefit analysis of an LLC, make sure you understand the true implications of its structure. Because it turns out that the very same reasons an LLC may appeal to you may be reasons why investors may decide not to join your company.
Some Investors Won't Invest in An LLC
Some angel investors are not inclined to investing in an LLC, as a matter of course, because of the subsequent tax issues. And of those investors who do come in, the potential tax issues may encourage them to take a smaller stake in an LLC than they would have in a corporation. More importantly, the venture capital funds cannot even invest in LLCs because their partners are often tax-exempt: They can't invest in any entity that would result in these partners receiving active income from any pass-through entities.
Long-Term Investors Can't Exclude LLC Gains from Tax
Under section 1202 of the Internal Revenue Code, investors who have held onto “Qualified Small Business Stock” for at least five years are eligible to claim a tax exemption for 50% of the gain they receive from a subsequent sale of that stock. And if they reinvest, they may reduce their tax liability even further. But this exemption only applies to investors of corporations. LLC investors are not eligible for this tax break.
LLCs Complicate Employees' Equity Stakes
Of course, a tried-and-true way to entice potential employees and others to join a startup (especially companies with limited payrolls) is to offer equity positions in the company. However, since an LLC is a partnership, an LLC cannot give employees stock, stock options, or stock-purchasing plans. Instead, the closest equivalent is to offer “profits interests,” a commitment to give the employee a portion of the company's increased value.
Given that startups often struggle to come up with a solid valuation, this may seem like too much of an unknown for both the company and its employees to accept. Also, profits interests can pose important tax issues for an employee—to the point that they may no longer even be a W-2 employee.
LLCs Complicate Investors' and Others' Equity Stakes
While corporations can issue investors preferred stock (e.g., stock that comes with seats on the board or liquidation privileges), LLCs cannot issue different classes of stock in the company. LLCs can issue different classes of ownership interests instead, but these are difficult for the company to administer.
Also, LLCs may have much less appeal than a company offering a more traditional stock package simply because investors are much less familiar with this type of offering.
If you are beginning a startup, bringing on a startup attorney early on is one of the best investments you can make in your company. For example, a startup attorney can advise you on how different legal structures make your company more (or less) appealing to investors and vested employees and how to set a valuation for a friends and family investment round.
Attorney Mohsen Parsa is a highly skilled business, corporate, and startup attorney in the Irvine, California area with a long track record of representing startups. He will help protect you now while giving your company a strong foundation for the future.