LLC Vs C Corporation For Startups: A Short Explanation

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.

Corporate Structure For A Crowdfunding Business

Crowdfunding Organizational Structure

I am asked this question so often, I thought it would be worthwhile to post a diagram of a Crowdfunding Organizational Structure of a relatively simple organizational structure for a Crowdfunding business.

If I’ve done this right, the diagram should be self-explanatory. Nevertheless, I’ll make one point about choosing the right entity.

When you start the business, you have to decide whether to form the Parent (see the diagram) as a limited liability company or as a C corporation. For the reasons discussed at length here, the right answer is almost always a limited liability company. But sometimes an institutional investor will insist on a C corporation, probably because the investor itself has limited partners that are tax-exempt entities and want to avoid paying tax on “unrelated business taxable income.” And if they’re investing enough money you’ll do what they want, despite the extra tax cost for you personally (that’s why they call it capitalism).

Until and unless that happens, use the limited liability company. It’s easy to switch if you have to.

Questions? Let me know.

C Corp Vs. LLC: What’s The Right Choice?

Ryan Feit, the CEO of SeedInvest, just published a great piece in Inc. Magazine about the pressure some entrepreneurs feel from venture funds to convert from a limited liability company to a C corporation. Ryan points out that the tax cost associated with a C corporation often makes the LLC the better choice.

It’s a question I’m asked all the time. And like Ryan, I normally come out on the side of the LLC for Crowdfunding companies, at least so far.

To flesh out the issue, I’ve written an overview, Choosing The Right Legal Entity MSR describing the main characteristics I’m thinking about when I recommend LLC or C corporation. If you want to understand why corporate lawyers seem so isolated at social gatherings, take a look.

Choosing the Right Legal Entity Flyer

Questions? Let me know.