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Founder's Dilemma: Is An LLC, C-Corp, Or S-Corp The Best For A Tech Start-Up?

This question originally appeared on CoFoundersLab: LLC, S-Corp, or C-Corp for tech start-ups?

Answer from Peter Weiss, President at American Outlook, Inc.



If you are going to need substantial equity infusion(s), you should start and stay with a "C" corp.


If you are based in New York City and choose LLC (assuming pass-through tax status, which is the main reason for using an LLC), all of your investors will receive K-1s and will likely will have to file New York State and City returns and pay taxes on the allocated income, whether or not you have done cash distributions to cover the obligation. For smaller investors, the cost of the tax return alone can be a disincentive.  


There are operational and financial reasons to avoid unnecessary conversions from LLC to corporation. While the conversion is relatively simple from a legal and tax perspective, you will have a new EIN/TIN, which means you need to reopen or restart bank accounts, insurance policies, credit histories, ratings based accounts like unemployment or workman's comp, etc.  You will also have to change "LLC" on all your webpages, printed materials, business cards, etc. to "Inc."  


One of the most important reasons for being careful about conversion is that when you become profitable, you will have no tax loss carry forwards to shelter your first taxable income, which means you will probably need to find additional capital to the extent that you have to pay taxes sooner.  For example, if you lose $2 million prior to profitability and pass the losses to the LLC owners, you will have foregone $2 million in offsets to taxable profits when you convert. At a combined 40 percent tax rate (and in NYC it might be higher), that's $800,000 in taxes that the company will pay, which could be retained for working capital or invested in future growth.


LLCs are great for companies that will not need equity infusions and are expected to generate lots of free cash flow. However, they are best used in situations where the structure can be relatively stable.  


One more challenge with the LLC conversion: If the company has a negative net worth when you do the conversion, then the LLC owners have attributed taxable income because the LLC's obligation is extinguished when the corporation assumes the liabilities. For example, if the LLC has $1 million of notes and accounts payable that are assumed by the new corp, then that $1 million becomes income to the owners when the LLC closes its tax books. Using a blended 40 percent tax rate, this means writing tax checks for $400,000 without receiving cash.  


You can solve this problem by converting the debts to LLC units prior to conversion, but this requires multiple steps and cooperation from the creditors.  It is workable with convertible note holders, but difficult with trade payables.

 

LLC, S-Corp, or C-Corp for tech startups? originally appeared on CoFoundersLab — the place to connect, meet, and collaborate with like-minded entrepreneurs.

 

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