More on LLCs

Two days ago, I lamented about how much of a pain LLCs can be for investors. The comments were lively.

Many people pointed out the “double taxation” issue involved with C corporations. C Corporations pay taxes and then when money is removed from the corporation to the investors or founders, another round of taxes is imposed. On the surface, this is a good argument for an LLC but it turns out to not have much of an impact in reality much of the time.

The other issue that people pointed out is that valuable losses can be passed through to the personal taxes of the investors and founders with an LLC. While this is also true under ideal circumstances, it turns out to not be true at all in most common cases.

Victor Fleischer reached out to me by email with a thorough research paper called “The Rational Exuberance of Structuring Venture Capital Startups” he had written on this very topic in 2003. I found it to be very educational and I think you will too. It’s absolutely worth a full read (10 minutes or so) – and it’s not as long as it looks because there are many detailed footnotes and supporting references.

Here’s the gist of his paper as I read it. Many observers of the venture capital industry believe that VCs ignore LLCs primarily because C corporations are the devil they know, and secondarily because they’re focused on gains only and are not typically major participants in losses (since they are investing other peoples money and not their own, primarily). This paper goes a long way towards showing why professional investors prefer C corporations and includes many potential surprises such as:

  • Tax losses are often not as valuable as they seem on paper as tax rules prohibit many investors (and entrepreneurs) from capturing the full benefit of the losses.
  • Corporations are less complex than partnerships. “Friction” costs associated with LLCs may make legal costs substantially higher over time for LLCs.
  • Gains are taxed more favorably when companies are organized as C corporations from the beginning (vs converting late, if that is even legally possible).
  • Employee compensation issues are much more complex with an LLC than a corporation. This can cost more and can devalue “options” equivalents coming from LLCs.

In short, at least in my mind, much of the argument for LLCs as being more tax efficient ends up being an illusion and only true “on paper.”

I hope that this starts another big argument. Blogging is for learning, and your comments and participation are really helping me learn. I thank you for that.

Keep in mind the paper is a little old and some tax laws may have changed in the interim. As always, consult your attorney and accountant as I’m no tax lawyer.

Incidentally, Victor is returning to CU as an Associate Professor at the law school this June! I’m glad to welcome him back to Boulder after he spent the last few years at the University of Illinois College of Law. I’m excited that he’ll be an asset to the local entrepreneurial community once again.

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file under: Blog, Startups, Venture Capital

6 responses to “More on LLCs

  1. We're an LLC, but we don't expect to raise VC. If I were starting a company today I'd prob do it as an S and then convert if necessary. Do you know if it's hard to go from S to LLC?

  2. S is an election on a C corp. You can unelect S any time quite easily. Going from S to LLC is the same as going from C to LLC – you can't “convert”, you have to create a new entity and transfer stuff.

  3. I guess I dont understand the double taxation issue. If I make a million dollars at abc, inc I am taxed at ~ 35% in the corp. If I then withdraw the $650k as a dividend I pay the dividend tax of 15-20%, soon to go much higher under Obama I assume. Correct? effective tax rate is over 50%, no?

  4. I guess I dont understand the double taxation issue. If I make a million dollars "profit" at abc, inc I am taxed at ~ 35% in the corp. If I then withdraw the $650k as a dividend I pay the dividend tax of 15-20%, soon to go much higher under Obama I assume. Correct? effective tax rate is over 50%, no?

  5. One thing I know for sure is that an LLC and S corp allow you to asorb a lot of expenses that you cant personally with getting hit with AMT.

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