Tag Archives: S Corporation

Skip the LLC

“My startup will start out as an LLC and then change to a corporation when/if…” This quote, or similar derivation, is a common fact pattern I hear from new clients or general inquiries. I think most entrepreneurs are attracted to the LLC because they hear it is “simple” or “easily-managed” or “flexible.”

Sure, LLCs are all of those. But remember that the LLC was created for tax reasons, and not for typical startup company legal maneuvers like raising capital or employee incentive compensation.

Thus, if there is any possibility that your startup will raise capital, I would skip the LLC and proceed straight to the corporation. Additionally, if you plan on giving your current or future employees incentive compensation, skip the LLC as well.

Of course, you can convert your LLC to a corporation when it is time to raise capital or grant stock options. Just keep in mind that converting from an LLC to a corporation later will be another round of filing fees with the secretary of state and legal fees (if you hire counsel).

If you really want pass-through taxation, file form 2553 with the IRS and elect to be a S-Corporation. And if you still want to be an LLC, check out my article on LLCs.

Why Startups are a Corporation for Venture Capital

Choosing a startup’s legal entity can be a frustrating experience for the entrepreneur. Who has time to deal with the LLC, S-Corp, C-Corp, LP, GP, LLP & LLLP when you’re already buried with things like CSS, RoR, AJAX, PYTHON, PHP & ASP? Thankfully, if your startup is absolutely determined to raise venture capital, there’s only one viable legal entity decision your startup can make–the Corporation. Here’s why your startup will be structured as a corporation for venture capital investment:

Does this include S Corporations?

No. While the S Corporation structure is a popular choice for entrepreneurs and other small businesses, it comes with regulatory limitations that do not make it a feasible vehicle for raising venture capital. The three main regulatory limitations are:

  • S Corporations may only have one class of stock;
  • S Corporation stockholders must be natural persons (except for some extremely limited circumstances); and
  • S Corporations can not have more than 100 stockholders.

The one class of stock requirement is fatal to a venture capital investment since venture capital firms will demand preferred stock in return for their investment. Also, most venture capital firms are organized as limited partnerships and less frequently as LLCs–but both legal entity types aren’t “natural persons.” And finally, as your startup grows, the 100 stockholder maximum comes into play once your startup begins issuing stock and stock options to employees.

Thus, the only type of viable corporation for venture capital investment is the C corporation.

Why not an LLC?

While the LLC is also a common startup vehicle, the C Corporation wins hands down when it comes to raising venture capital. The following 4 reasons explain why the LLC is suboptimal compared to the corporation for venture capital:

1. Pass Through Entity

While the pass through feature (income/losses are passed down to the shareholders rather than dealt with at the entity level) of LLCs are desirable to most entrepreneurs, venture capital funds do not find pass through taxation to be a similarly desirable feature. The venture capital firm does not want the accounting and tax matters of a funded venture to be passed down to the firm, and thereby be attributed to the venture capital firm’s tax exempt and foreign limited partners. Such a scenario could create unrelated business taxable income (UBTI) issues or have their foreign investors be deemed “doing business” in the United States and thus have to file a U.S. tax return.

2. Transferability

The membership interests of an LLC are typically not freely transferable by state statute. This makes the LLC a lousy entity for one of venture capital’s exit strategies: the IPO. (Not that IPOs for venture backed companies are hot at the moment.)

3. Predictability

Started in the late 1980s and only made more popular in the last decade or so, LLCs are a relatively new type of legal entity. Thus, there just isn’t a well developed set of laws and regulations for LLCs. Corporations, on the other hand, provide a larger degree of predictability with regards to corporate governance and stockholder rights.

4. The Venture Capital Firm’s Organizational Documents

Primarily due to the reasons outlined above, many venture capital funds will have specific provisions in their own organizational documents that prohibit them from making a venture capital investment in an LLC, or any other legal structure than a C Corporation. Thus, if your startup is absolutely against being a C Corporation, you could be declined by the venture capital firm regardless of how spectacular your startup is.

The Conclusion

The C Corporation is a venture capital firm’s clear-cut choice for the type of entity in which to place their investment. When the to-be-venture-funded startup is a C Corporation, various administrative and other burdens are minimized for the venture capital firm, which allows them (and their capital) to focus on developing the startup company’s business. You startup should be structured as a corporation for venture capital.

How to Make a Late Election for S-Corporation Status

Filing for S-corporation status with the IRS requires compliance with strict time guidelines. Form 2553 must be filed by the 15th day of the third month after your corporation’s fiscal year. For most corporations, that means you must file by March 15 for the S-Corporation election to be effective for the current fiscal year.

If you file Form 2553 late, your election to be an S-corporation becomes effective the next fiscal year. However, if you qualify, you can file late and make your S-corporation election retroactive using IRS Revenue Procedure 2003-43. Your corporation will qualify to file Form 2553 late if:

1. Your corporation intended to be an S-corporation as of the intended effective date on your Form 2553;

2. Your corporation failed to obtain S-Corporation status solely because it did not file Form 2553 on time;

3. The original due date of your Form 2553 was less than 2 years ago;

4. Your corporation had reasonable cause or inadvertently failed to file form 2553 on time;

5. Your corporation has not filed tax returns for the year(s) it intends to be an S-Corporation (or your corporation filed tax returns as an S-Corporation using Form 1120S);

6. You file Form 2553 within 6 months after the original due date (no extensions) of the first tax return for which your corporation intended to be an S-Corporation; and

7. All of your corporation’s shareholders have not reported income in a manner inconsistent with your corporation’s intention to be an S-Corporation.

If you meet these requirements and wish to file a late election for S-Corporation status, write the following language at the very top of your Form 2553: “FILED PURSUANT TO REV. PROC 2003-43” and include a statement, on a separate sheet, addressing requirement #4 above. And make sure all shareholders sign both documents.