Why a venture startup needs to be a C-Corp and not an LLC

At least once a week, I see a pitch deck for an interesting early-stage startup. But when I look into the details, I find out the company is structured as an LLC instead of a corporation.

When I ask why, I always get the same answer — it’s what our lawyers or accountants advised. Unfortunately, that means the founders are trusting advisors who work with small businesses instead of venture-backed startups and are giving them the wrong advice for their situation.

For a startup planning on obtaining funding from venture funds and angel investors, there is only one choice for corporate structure — a C-corp, ideally incorporated in Delaware.

Corporation vs LLC

Unlike a regular business or a partnership, which is an extension of the owners, a corporation is an independent entity and the owners and shareholders are not personally liability for anything that happens inside the company.

If a corporation is sued for a billion dollars, any judgement comes out of the company’s pockets, not the owner’s. In the worst case, if the company goes bankrupt, the shareholders lose their investment, but nothing more. If the company does something illegal, the managers can be sent to prison, but shareholders hardly need to worry about the police knocking at their door.

This liability shield makes it easy for anyone to buy and trade shares in giants like Apple or GM, or invest in tiny startups and not have to worry about anything other than the value of the shares.

The downside is that as a separate entity, the corporation has to pay taxes on its profits. That means the corporation’s profits are taxed, then distributed to owners, who then have to pay tax again on the dividends they receive as personal income.

The corporate structure is fine for big businesses like Apple or GM, but if I open a shoe store, I don’t want to have to pay corporate taxes on the shoe store’s profits, then pay taxes on those same earnings again as personal income.

But I want my friends to be able to invest in my shoe store, and I want to offer incentive shares to my managers and employees, so I need a corporate structure that provides a liability shield.

To support small businesses in the US, the IRS created the S-Corp (small business corporation) and later, the LLC (limited liability company). The traditional corporation is referred to as a C-corp (which just means Corporation corporation).

S-Corp/LLC structures provide the liability protection of a corporation, but are exempt from corporate taxes. Instead, the profits are divided up pro-rata by ownership and taxed only as part of personal income.

For a profitable small business, the benefit of not paying corporate taxes can be huge. The US corporate tax rate is currently 21% (down from a maximum rate of 38% pre-Trump). Add to that an 8.84% corporate tax in California, if the company operates there, and you’re avoiding handing over 30% of your profits to the government by being structured as an S-Corp or LLC.

If I was opening a shoe store, it would certainly be an S-Corp or LLC. My rental properties are in an LLC entity. All venture funds are structured as LLCs. But an LLC does not meet the requirements of a venture-backed business.

Venture Startups are Not Small Businesses

The goal of a venture startup is not to build a small business to generate and distribute profits. If successful, the startup will reach hundreds of millions in revenues within a few years, and quickly be acquired by another company or go public in an IPO.

The goal for investors is to make money from selling the stock rather than receiving dividends. This is quite different from private equity (PE)-backed companies that are focused on maximizing cash flow and dividends.

Rather than think of a startup as a small business, it is better to consider it a big business in its infancy. While the size of the business may be small, it needs to be structured for its intended purpose rather than its initial size.

S-Corps are Non-Starters

S-Corps have a number of critical limitations that make them completely unsuitable for venture-backed startups.

  • Only one class of stock
  • Only 100 shareholders
  • Shareholders must be U.S. citizens or permanent residents
  • Shareholders must be individuals, not other corporations

This means that if Disney wants to invest in your entertainment startup, they can’t if it’s an S-Corp. It means your friends in London can’t invest, nor can your college classmates on student visas.

More importantly, it doesn’t work with the venture investment structure. Each round of investment in a startup (Series A, Series B, etc…) is a separate class of preferred shares with its own voting rights, liquidation preferences, and other negotiated terms, all separate from the founders’ common shares. This multi-class stock structure is critical to how venture investment works, making an S-corp structure a non-starter.

LLCs Better But Not Good Enough

LLCs don’t have the same limitations on classes of shares (called “units” for an LLC) or shareholders (called “unit holders”). So it is possible to create a venture corporate structure using an LLC.

But LLCs have three problems that still make them non-starters for venture investors:

  1. K-1 tax reporting
  2. Loss of tax incentives
  3. Profits taxed even if not distributed

K-1 Tax Reporting for LLCs

A C-corp has to file its own tax reports every year, but that only affects shareholders if the company has issued dividends that have to be declared as income.

Big companies issue dividends quarterly. Startups never issue dividends. If they have any profits (rare for startups) the money is reinvested in growth rather than distributing to shareholders. And even if they did issue dividends (they don’t, but if they did…) reporting dividends on a 1099-DIV form only takes a minute, and all I need to report is how much I was paid.

As an investor, that means the only time I need to deal with C-corp startups on my personal taxes is when they’re wound up — either the stock is sold for a gain or loss or I write off the investment as a failure.

For LLCs, though, the profits and losses of the company each year have to be attributed pro-rata to the individual owners on K-1 forms that are issued to every shareholder, whether they own 10% of the startup, or one share worth $1.

The K-1s are supposed to be issued by March 15, giving shareholders a month until their personal taxes are due on April 15. Unfortunately, few startups are able to complete their taxes and issue K-1s by March 15, so they apply for extensions, giving them until Sept 15. But that means that I, as a shareholder, can’t start working on last year’s taxes until Sept. or Oct. of the following year, even though payment for the taxes that I can’t calculate remains due April 15.

That would almost be okay, except many startups don’t even finish by that extended deadline, and many that do later find errors and have to reissue their K-1. When that happens, I have to amend and update my personal taxes. Uggh. That’s no fun.

K1s aren’t simple documents like a 1099 with a couple of boxes for amount of interest or income paid. They’re 25 page tax forms calculating income, allowed and disallowed expenses, amortization schedules, and owner’s share of income and deductions, prepared separately for federal and state taxes which have different tax rules. If there’s any foreign income, add yet more schedules. Any mistake in the startup’s accounting, such as not properly amortizing R&D costs, has to be fixed and updated, which means my personal taxes have to be amended, again.

Having one K-1 in my tax reporting is annoying. If I invest in 25 different startups (the minimum for a viable startup portfolio) and they all issue K1s, my taxes would be impossible to prepare.

Simple answer is I don’t want to deal with K-1s. It’s not worth the hassle for a $10K or $100K investment. So I won’t invest in startups that issue K-1s, meaning if you pitch me an LLCs, sorry, the answer is no.

Tax Incentives for C-corps

Yes, C-corps have to pay corporate taxes and LLCs do not. But, C-corps are eligible for some very tasty incentives not available to S-corps and LLCs.

  • Section 1202: There is NO income tax on the gains of a startup investment so long as it’s a C-corp and the stock is held for 5 years (and eligible for 50% tax reduction after 3 years and 75% after 4 years.) This is a huge incentive to invest in early-stage startups.
  • Section 1244: Losses on the first $1M invested in a failed C-corp can be deducted against regular income instead of against capital gains. When 90% of very early-stage investments fail, this is incredibly helpful.

Profits Taxed Even if Not Distributed to Owners

Let’s say a startup has a great year. They generate $25M in revenue. They didn’t have time to hire all the new people they planned or invest it all in marketing, so they end the year with a $5M profit. Woohoo!

The K-1 will show a $5m profit. If I own 1% of the stock in the company, guess what — I have to add $50K of income to my taxes, meaning I’ll have to pay around $20K in taxes. Even though the company will never send me that $50K of profit but keep it to use itself next year.

The only thing worse than losing money is having to pay tax on income you never receive.

No Downsides to C-Corp

The only reason to set up a startup as an LLC instead of a C-corp is to avoid taxes on company profits. But startups don’t have profits except in the rare case of income that can’t be reinvested in growth fast enough, so it’s almost always a moot point.

In theory, the losses from an LLC could be applied to reduce our personal income, a seeming benefit. However, for investors, passive losses can’t be written off against regular income, so loses on a K-1 don’t help me.

As an investor, my answer is simple — I only invest in C-corps. This is universal — any venture fund or serious angel investor will say the same thing. Friends and family may not know the difference, but that doesn’t mean you won’t be making tax day hell for them when you send them their K-1.

What To Do if Your Startup is an LLC?

You’ve already set up your corporate entity as an LLC. You got bad advice from your advisors.

The first thing to do is find better advisors. Any accountant or lawyer familiar with the venture world instead of small business will know you need to be structured as a C-corp.

Once you find the right advisors, have them help you convert the business to a Delaware C-corp. Essentially, you create a new C-corp entity, then fold the assets of the LLC into the new business.

The earlier you do this transition, the simpler, faster, and cheaper it will be. If you don’t yet have investors, customer purchase agreements, supplier contracts, employee option plans, etc., the process is straightforward and takes about a month.

Anything tied to the LLC entity will need to be converted, which may require agreements, filings, approvals, and signatures, adding time and cost. That’s why you should structure as a C-Corp from the start if you can. If you’re an LLC pitching to investors, get started converting now.

The startup, SüprDüpr, is a C-corp, which allowed them to raise a billion dollars from Satoshi Nakamoto and Bitecoin Ventures. So why are they using the investment to build homeless shelters? And why is their Chief Elephant Officer missing?

Find out in the Silicon Valley mystery novel, To Kill a Unicorn.