C-CORPs vs. LLCs: Advantages and Disadvantages for Startups
The issuance of convertible preferred stock by C corporations is the typical vehicle for venture capital investments.
Venture capitalists typically will not invest in LLCs and may be precluded from doing so under their fund documents.
Traditional Equity Compensation
C corporations can issue traditional stock options and “incentive stock options.”
It is more complex for LLCs to issue the equivalent of stock options to their employees. “Incentive Stock Options” also are not available to LLCs.
C corporations can participate in tax-free reorganizations under IRC Section 368.
LLCs cannot participate in tax-free reorganizations under IRC Section 368.
Sale of Equity or IPO
C corporations can engage in traditional equity financings.
An LLC will need to transfer its assets to a new corporation before entering the public equity markets because investors are more comfortable with a “typical” corporate structure. This preparation and transition will result in additional expense and complexity.
Reinvestment of Capital
A C corporation’s income does not flow or pass-through to its shareholders; this makes it easier to retain and accumulate capital.
LLC’s pass-through taxation makes conservation of operating capital difficult. LLCs typically distribute cash to enable members to pay the taxes on their share of the LLC’s income. LLC members are taxed on the income of the LLC allocated to them regardless of whether any cash is distributed to them.
Level of Tax
A C corporation’s income is subject to tax, and any “dividend” distributions of earnings and profits to shareholders that have already been taxed at the C corporation level are also taxable to the shareholders (i.e., income is effectively taxed twice).
LLCs are pass-through entities: their income is subject to only one level of tax, at the member level.
Pass-Through of Losses
A C corporation’s losses do not pass-through to its shareholders.
Generally, losses, deductions, credits, and other tax benefit items pass-through to an LLC’s members and may offset other income on their individual tax returns
Because there is no pass-through of income in C corporations, this is not true in C corporations.
Members receive a basis step-up in their LLC interests for income left in the LLC and not distributed.