Originally published September 22, 2014
If you're about to form a start-up, you may be trying to decide between forming a corporation or an LLC. Although many considerations go into this determination, important factors for you to consider are your proposed funding and hiring plans.
Funding Plan
If you're expecting to raise $1 million or more in your first round of financing, then you will likely be seeking venture capital. Venture capital firms, which are typically limited partnerships, generally prefer to invest in a C-corporation rather than an LLC. A venture capital firm will often shy away from investing in an LLC (i) to avoid the profits and losses of the LLC (and the tax implications related thereto) being attributable to the individual partners of the venture capital firm, as an LLC is a "pass through" entity for tax purposes (see Business Week Article)1, (ii) so that a venture capital firm's otherwise tax-exempt partners (e.g., pension funds, charities, endowments) are not subject to unrelated business income tax (UBIT) (see 26 U.S.C. § 511 et. seq.)2, and (iii) due to a venture capital firm's general familiarity with investing in C-corporations.
However, if your start-up does not need outside capital, or is able to raise capital from individuals or from investors who prefer or are comfortable with flow-through tax treatment, an LLC may be appropriate.
Hiring Plan
If you intend to hire individuals who are to be incentivized by the issuance of stock options or restricted stock, you should form your start-up as a corporation. A corporation may generally set up an incentive stock option and restricted stock plan in a cost-efficient manner and incentive stock options and restricted stock may be issued by the corporation to its employees in a tax-efficient manner. Just as importantly, most employees are familiar and comfortable with both stock options and restricted stock.
On the other hand, stock option plans for LLCs are not permitted by IRS rules. Instead, LLCs may adopt phantom equity or profits interest plans. Although employees are less familiar with these types of plans and such plans can be less cost-efficient to put in place and less tax-efficient with respect to the employee recipients of phantom equity or profits interests, these types of plans are viable alternatives if there are other compelling reasons to form your start-up as an LLC.
Footnotes
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
