Avoid Becoming an LLC as a Startup
Business structure is an important decision for new startups. Will you operate as a sole proprietor, making your name directly connected to the business? Or–more likely–will you incorporate into a structured business entity?
The three most common business entities are C Corporations, S Corporations, and LLCs. While we won’t discuss the merits and flaws of the first two in this piece, we will cover some compelling reasons why startups should avoid incorporating as an LLC. All of these reasons have to do with the fact that an LLC comes with certain implications that make it unattractive to investors–and a startup that can’t get investors is a startup doomed to fail.
Here are the factors that make an LLC a poor choice for startups seeking investor capital.
1. Investors face unattractive income tax implications
With a pass-through entity like an LLC, tax liabilities are passed through to individual owners. This means that anyone who invests in an LLC will be taxed on the business’s income, even if they personally received no distributions or profits. Understandably, most people aren’t chomping at the bit to make their taxes even more complicated!
2. Some investors can’t invest in pass-through companies at all
Even if an investor was willing to take on a share of business taxes, they may not be allowed to. For instance, a venture-capital fund with tax-exempt partners legally cannot receive active business income.
3. It also complicates location-based taxes
State taxes add yet more complications to an LLC setup, because investors may face income taxes in a state where they do not live. It creates an extra headache for them at tax time even though they had no control over the circumstances.
4. Ultimately, simplicity is key
As a new business, you face enough of an uphill battle convincing investors that your idea is worth their hard-earned dollars. Adding more complications into the mix, as you would by incorporating as an LLC, only puts one more barrier in your way.
The decision between an S Corp and a C Corp is dependent on other factors about your business, but this decision at least is clear: if you want investors, stay away from LLCs.