When forming an LLC is not the right choice.

When most entrepreneurs establish a business, one of the last things on their minds is what kind of entity to use to conduct their operations. Understandably, founders would prefer simplicity, low cost, and the least amount of distraction from the thousands of other tasks that must be completed to get their startup off the ground. However, setting up an entity is necessary if founders hope to attract investment and limit personal liability. A crucial choice that must be made when forming a business is the kind of entity developed. This decision will have implications for the firm’s founders and workers and those investing in the organization.

Most individuals who propose founding an LLC point out that doing so allows you to avoid the “double taxation” that may occur via the formation of a C company. The term “double taxation” refers to the fact that the profits of a C corporation are taxed twice: first at the corporate level (the corporation pays the first tax), and second, if those profits are distributed to the corporation’s shareholders in the form of dividends, the shareholders must pay tax on those dividends.

Why shouldn’t a company’s founder choose to form a limited liability company?

LLCs are typically not the best choice for technology or growth companies that want to follow the traditional path of regular and ongoing equity grants to employees, multiple rounds of financing, and reinvestment of as much capital into the business as possible with the goal of eventually selling to a large, possibly public company in exchange for cash and stock.

  1. Many investors are unable to invest in limited liability companies.

Some investors cannot participate in pass-through firms because they have tax-exempt partners who do not want to obtain active trade or company revenue due to their tax-exempt status. As a result, they cannot invest in pass-through companies. Additionally, many accelerators demand that entrepreneurs form a C company before being accepted into their accelerator program.

  1. Raising Capital Through an LLC Is More Difficult Than Through a Corporation

Obtaining additional financing via a limited liability company is far more complicated than raising a subsequent round of cash through a corporation. Company limited liability agreements (LLC agreements) are more complex and complex to draught than their corporation equivalents.

Aside from that, you may encounter sticky and very complicated tax difficulties in the context of a limited liability company that does not exist or develop in a corporate environment. On the other hand, most financings are based on commonly used agreements set up for C companies, which decreases the complexity and legal expenses associated with acquiring cash.

  1. In a limited liability company, equity compensation is complicated.

 

Providing equity remuneration to workers, advisers, and other service providers is one of the most enticing incentives that companies can give to their employees, advisors, and other service providers. Individuals seem to have a broad comprehension of how these devices operate. However, offering equity compensation in organizations taxable as partnerships is far more complicated and costly to create and run than giving equity pay in a business taxed as a C corporation.

Alternatively, a “profits interest” is the LLC’s version of stock grants. The issuance of profits interests often results in the LLC “booking up” the owners’ capital accounts before giving the profits goods. A similar problem arises when options or warrants to buy LLC interests are exercised. A W-2 employee who gets a profits interest will also be recognized as a partner for tax reasons, and she will no longer be able to claim the status of a W-2 employee.

  1. LLCs have the potential to complicate investor tax situations.

Investors usually do not want to complicate their tax status by becoming a member of a company taxed as a partnership, and limited liability companies (LLCs) are the entities that are taxed as partnerships the most commonly. Members of LLCs that are taxed as partnerships include:

  • Form K-1 from the entity detailing how revenue and losses are allocated to the member;
  • Nevertheless, it is possible for members to be taxed on the LLC’s profits even if no cash is transferred to you to pay the taxes.
  • When the K-1 is received, the investor’s ability to submit its tax return is reliant on it, and if there are difficulties with the K-1, the investor may be required to modify its tax return.
  • Depending on whether the company is engaged in an active trade or business and does business in other jurisdictions, investors may be liable to income tax in those other states, requiring them to file tax returns in several states.
  1. Convertible debt may be challenging to manage and might have negative tax implications.

To avoid adverse tax effects, convertible promissory notes issued by a limited liability company (LLC) taxed as a partnership must be structured differently from directives issued by a corporation that is treated as a partnership.

For investors, phantom income (also known as taxable income without the receipt of cash) might emerge from the conversion of the note itself if the transaction is not correctly handled. In addition, if the business fails to make it, the founders may be required to accept debt forgiveness upon the dissolution of the limited liability company.

  1. Many investors prefer the familiarity and simplicity of owning stock in a C corporation over other investment vehicles.

Since members can be LLCs are less recognizable to investors than corporations, investors must often spend more time doing due diligence and reading the underlying documentation before deciding whether to invest. Because of this, they have to spend more money on due diligence and more time studying the startup’s entity when they might be spending that time learning more about the startup’s business and prospects.

In most cases, investors in early-stage enterprises simply wish to make an investment and acquire shares without having to worry about any further tax issues (such as a Form K-1 or prospective taxes in other states) until the stock is sold and a capital gain or loss is realized.

Conclusion

This commitment may necessitate distributing a large number of the LLC’s revenues to its members, depending on the circumstances. On the other hand,  companies are now subject to a low federal tax rate of 21 percent, allowing them to preserve more money to invest in the expansion of their businesses.