Like COVID, the questions around choosing a limited liability company or C corporation for startups never seem to go away.
For lots of details see the article I wrote here. Except for making you the center of attention at the party, however, those details don’t matter very much. So I’m offering this short version.
In a limited liability company you pay only one level of tax upon a sale of the company, while with a C corporation you pay two levels. That can make an enormous different to the IRRs of founders and investors.
Yet many startups are formed as C corporations. Why?
In Silicon Valley successful startups are funded by venture capital funds. Indeed, the most common measure of “success” in Silicon Valley is which venture capital funds have funded a startup, for how much, and how many times.
Venture capital funds are themselves funded, in part, by deep-pocketed nonprofits like CALPERS and Harvard.
All nonprofits are subject to tax on business income, as opposed to income from their nonprofit activities. For example, Harvard can charge a billion dollars per year in tuition without paying tax, but if it opens a car dealership it pays tax on the dealership’s profits. The car dealership income is called “unrelated business taxable income,” or UBTI.
Now suppose Harvard owns an interest in a VC fund, which is structured as a limited liability company or limited partnership (as all are). If the VC fund invests in an LLC operating a car dealership, then the income of the dealership flows through first to the VC fund and then from the VC fund to Harvard, where it is again treated as UBTI, subjecting Harvard to tax and reporting obligations.
Harvard doesn’t want to report UBTI! So Harvard tells the VC fund “Don’t invest in LLCs or partnerships, only C corporations, where the income doesn’t pass through.” And because Harvard writes big checks, the VC fund does what Harvard wants.
That’s why the Silicon Valley ecosystem uses C corporations. Everyone knows about the extra tax on exit, but everyone is willing to pay it on exit to get the big checks from Harvard.
I will pause to note that in many cases the nonprofit’s concern about UBTI is illusory. Many startups never achieve profitability, including startups sold for big numbers. So there would never have been any UBTI in the first place.
(Yes, I know that there’s no extra tax in an IPO or tax-free reorganization, but those are small exceptions to the general rule.)
Because Silicon Valley is the center of gravity in the American startup ecosystem, like the black hole at the center of the Milky Way, it exerts a force that is not always rational. Many investors, including funds with no nonprofit LPs and hence no possibility of UBTI, will tell startups “I only invest in C corporations,” simply based on the Silicon Valley model.
This creates a dilemma for founders, especially in the Crowdfunding space. If I’m an LLC and list my company on a Reg CF platform, how do I know I’m not losing investors who think, irrationally, that they should only invest in C corporations?
In any case, that’s where we are. LLCs are better in most cases because of the tax savings on exit. But because of the disproportionate influence of the Silicon Valley ecosystem in general and deep-pocketed nonprofit investors in particular, many investors and founders think they’re supposed to use C corporations.
Questions? Let me know.