Startup Company Blog : Seattle Startup Lawyer & Attorney : Davis Wright Tremaine Law Firm : Emerging Companies & Venture Capital

 I frequently meet with entrepreneurs after they have created their business entity and put some of the initial legal documentation in place.  I frequently see the following mistakes, which can be easily avoided and save time and money for entrepreneurs later.

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I typically prefer C corporations as a choice of entity for early stage technology companies.  However, occasionally a pass through entity is the right choice of entity, especially when the founders will fund the initial losses and want to deduct those losses on their individual tax returns (i.e., pass through income tax treatment).  Which raises the question, what is the better choice of entity today for a startup company whose founders are going to be actively involved, fund early losses, and want the ability to deduct those losses on their personal income tax returns—an LLC (for this purpose, one assumed to have multiple members and taxed for federal income tax purposes as a partnership) or an S corporation?  (Mind you, a flow through entity choice will cost the founders the qualified small business tax benefit of IRC Section 1202 and the rollover benefit of IRC Section 1045.)

The answer depends on a number of factors, including whether the founders want to specially allocate the early losses among themselves (meaning, share them other than in proportion to stock ownership). Special allocations aren’t allowed with an S corporation. But if there is no desire to specially allocate losses, I believe the S corporation is the better choice—assuming the entity meets the criteria for making an S election. Why?

• S corporations can participate in tax-free reorganizations -- S corporations, just like C corporations, can participate in tax-free reorganizations (such as a stock swap) under IRC Section 368.  LLCs with multiple members taxed as partnerships cannot participate in a tax-free reorganization under IRC Section 368.  This is a significant reason not to choose the LLC format if a stock swap is an anticipated exit strategy. The last thing a founder wants to discover on a proposed all stock acquisition is that the stock received will be taxed, even though non-liquid.
• S corporations can grant traditional equity compensation awards -- S corporations can adopt traditional stock option plans. It is very complex for LLCs to issue the equivalent of stock options to their employees, and although they can more easily issue the equivalent of cheap stock through the issuance of “profits interests,” the tax accounting for a broadly distributed equity incentive plan in an LLC can be very complex and costly. 
• S Corporations Can More Easily Convert to C Corporations -- It is typically easier for an S corporation to convert to a C corporation than it is for an LLC to convert to a C corporation.  For example, upon accepting venture capital funding from a venture fund, an S corporation will automatically convert to a C corporation. For an LLC to convert to a C corporation, it is necessary to form a new corporate entity to either accept the assets of the LLC in an asset assignment or into which to merge the LLC. Also, converting an LLC to a C corporation may raise issues relating to conversions of capital accounts into proportionate stockholdings in the new corporation that are not easily answerable under the LLC’s governing documents.
• There May Be Employment Tax Savings Associated With An S Corporation -- An S corporation structure may result in the reduction in the overall employment tax burden. LLC members are generally subject to self-employment tax on their entire distributive share of the LLC’s ordinary trade or business income, where S corporation shareholders are only subject to employment tax on reasonable salary amounts and not dividends.
• Sales of Equity and Initial Public Offerings -- S corporations can more easily engage in equity sales (subject to the one class of stock and no entity shareholder (generally) restrictions) than LLCs. For example, because an S corporation can only have one class of stock, it must sell common stock in any financing (and this makes any offering simpler and less complex). An LLC will often have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity (although its S corporation status will have to be terminated prior to such an event). As a practical matter, an LLC will need to transfer its assets to a new corporation or merge with a new corporation before entering the public equity markets because investors are more comfortable with a “typical” corporate structure.
• Simplicity of Structure -- S corporations have a more easily understandable and simpler corporate structure than LLCs. S corporations can only have one class of stock -- common stock -- and their governing documents, articles and bylaws, are more familiar to most people in the business community than LLC operating agreements (which are complex and cumbersome and rarely completely understood).

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LLCs taxed as partnerships as a choice of entity have their drawbacks, which we have discussed elsewhere.  However, LLCs do have one advantage over corporations when it comes to granting equity interests to service providers--they can grant what is know as profits interests to their partners.  

See IRS Rev. Proc. 93-27 and 2001-43.  A profits interest is an interest in an entity taxed as a partnership that entitles the holder to a share of profits in the entity going forward (and no share of the liquidation proceeds if the entity were liquidated immediately after receiving the interest).

The receipt of profits interest is not taxable to the recipient.  This is different from and a more advantageous treatment than the receipt of stock of a corporation by a service provider.  When a service provider to a corporation receives stock, the service provider will have an immediate tax impact if the stock is fully vested or if the service provider makes a Section 83(b) election.  If the stock is not fully vested, the service provider will have a tax impact upon vesting--when the stock may have risen in value.  

The recipient of a profits interest does not have a tax impact upon receipt or vesting.  

(See also IRS Notice 2005-43:  "This notice addresses the taxation of a transfer of a partnership interest in connection with the performance of services. In conjunction with this notice, the Treasury Department and the Internal Revenue Service are proposing regulations under § 83 of the Internal Revenue Code. The proposed regulations grant the Commissioner authority to issue guidance of general applicability related to the taxation of the transfer of a partnership interest in connection with the performance of services. This notice includes a proposed revenue procedure under that authority. The proposed revenue procedure provides additional rules for the elective safe harbor under proposed § 1.83-3(l) for a partnership’s transfers of interests in the partnership in connection with the performance of services for that partnership. The safe harbor is intended to simplify the application of § 83 to partnership interests and to coordinate the provisions of § 83 with the principles of partnership taxation. Upon the finalization of the proposed revenue procedure, Rev. Proc. 93-27, 1993-2 C.B. 343, and Rev. Proc. 2001-43, 2001-2 C.B. 191, (described below) will be obsoleted. Until that occurs, taxpayers may not rely upon the safe harbor set forth in the proposed revenue procedure, but taxpayers may continue to rely upon current law, including Rev. Proc. 93-27, 1993-2 C.B. 343, and Rev. Proc. 2001-43, 2001-2 C.B. 191.")

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