Avoiding the LLC Trap

Avoiding the LLC Trap

In the last twenty years, business owners and the attorneys who love them have both touted the limited liability company (LLC) entity as a flexible, tax-advantageous alternative to the traditional corporate model, and criticized it as an anemic younger sibling of the once and future C corp king. Some attorneys, accountants and other professional service providers warn entrepreneurs against forming LLCs by stressing the uncertainty of venture capital investments in entities taxed as partnerships, the possibility of having to convert from an LLC to a corporation at some point and other factors. But for most startups, the benefits of flexibility and favorable tax treatment associated with LLCs (versus corporations) outweigh the potential disadvantages these practitioners cite.

First, the reality of the small business ecosystem is that most startups will never receive venture capital funding. It’s true that professional venture capital funds sometimes avoid investing in LLCs because of potential adverse tax consequences as a result of receiving unrelated business taxable income (UBTI) from the flow-through income. However, this won’t be an issue for the majority of small businesses, whose focus in the early years of existence is on growth modeling, revenue, customer acquisition, etc., rather than courting venture capital companies.

Second, in the event an LLC does get to a point where venture capital is appropriate, the process of converting from LLC to C corporation is relatively straightforward. The reverse is not true: converting from a C corporation to an LLC “ or any other entity, for that matter, other than simply making an S election “ would be a deemed liquidation event for the business, and would be subject to considerable hurdles.

Finally, the fundamental tax benefit of LLCs at its core, avoidance of the so-called double tax that corporations experience “ cannot be overstated. Except in rare cases, startups operate at a loss in their earliest stages, and LLCs provide for a streamlined, and in most situations financially favorable, pass-through taxation model.

There isn’t a œone size fits all, definitive entity type for startups. Corporations have advantages in some situations. But early-stage startups should strongly consider forming LLCs, at least for the time leading up to major venture capital investments or other high growth.