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Master Case: Corporate Finance: Limited Liability or C-Corp

Context

A startup firm is concerned about three key tax issues.

  1. What is the optimal form of business organization for a startup firm?
  2. In case of liquidity event are there are any steps that founders can take to reduce their tax liability?
  3. Is the optimal form of organization different if the startup becomes an acquisition target or decides to acquire other firms?

Factors

We started by focusing on the business organization issue. We defined the optimal form of an organization as a form with the following characteristics

  1. Ability to capture and transfer all income and losses to owners in initial as well as later years. Initial years in a startup may result in significant losses. In later years depending on capital requirements, growth potential & market environment the firm may opt for an IPO. However till that decision is taken there is justification to minimize the tax impact of income as well as losses.
  2. Limited liability protection.
  3. Single layer of taxation.
  4. Attractiveness as an investment vehicle to sources of funding.
  5. Flexibility in converting to more liquid forms of organization. If for business reasons the firm decides to reorganize the option to chose other organizational forms should be open.
  6. Ability to maintain control. Voting control & operating control are related but somewhat different. Control is also subject to interpretation by case law.

The final decision is dependent on the stage /phase of the startup. Before breakeven is achieved its important that if the venture is terminated, the losses incurred to date are distributed to investors and owners. After breakeven is achieved and before a decision is to taken to use public markets for equity, it is important that the taxation layers are minimized. Finally when the firm does go public, it is equally important that the overall tax impact on owners, founders, the firm and investors is minimized. A trade off exists between the choices made at inception, access to capital markets and overall tax impact for owners & investors. This is reflected in the costs / frictions associated with a reorganization.

tection, sole proprietorship, general partnership and limited partnership were ignored in our consideration. Chapter S corporation was eliminated because of residency requirement of shareholders and limits on number of members. The two choices that remained were C Corporations and LLC’s. Table 1.0 presents a comparison of the two choices

Table 1.0

Factor LLC’s C – Corporation
Creation Permission by state lawFile agreement of operations & articles of organization Permission by state lawFile articles of incorporation
Profit & Losses By operating agreement Individual shareholders are not entitled to use losses
Liability Limited LiabilityNo personal obligation Limited LiabilityNo personal obligations
Capital & Financing Contributions set by agreement & may be cash, services, property and loans Stock, bonds & loans
Duration Articles of organizations and state law control duration. Dissolution is dependent on continuity of members May be perpetual
Transfer of ownership Limited by articles or organization & operating agreement Freely transferable
Management & Control Members and managers Vested in the board and managers
Taxation Informational tax return filed but no taxes. Triple taxation

The Choice – LLC

We decided that a limited liability company (LLC) was the optimal form of organization. The key reasons were the pass through of losses and income to members, limited liability, organizational flexibility & the single layer of taxation. However there were also issues relating to “Reorganization Flexibility”, “Material Participation” and “At-Risk Limitations”. For the purpose of this paper we limited ourselves to Reorganization Flexibility. Material participation and at risk limitations were ignored since in the reviewed literature they were subject to interpretation of IRS rules.

Reorganization Flexibility – Converting to a C Corp.

The biggest concern we had was with the ability to merge or acquire new firms and with transfer of ownership.

  1. “Because of the limited scope of reorganization, members may be faced with constructive termination for tax purposes resulting in income recognition and depreciation recapture5“. Based on this statement our assumption is that a termination would result in liquidation for tax purposes and a recognition of gains on firm assets. The gains would be taxed at the personal income tax rates of members since depreciation expenses, net losses and net gains flowed through the personal income returns of members. Which lead to an additional interesting insight that even though there may be capital gains generated by an LLC, the same gains would always be taxed under the personal income rates of members.

We thought that the right way to look at this choice would be as an option on organizational flexibility. The value of the option would be dependent on the following factors

  • Type of Option. Call Option on the success of organization and a subsequent IPO.
  • Type of Premium. Zero Premium on purchase. Contingent premium is paid if the option to convert is exercised.
  • Amount of Premium. Income taxes on the recognition of gain as a result of termination for tax basis
  • Exercise Criteria (Value created > Taxes paid as the result of termination) The option would only be exercised if the IPO creates value and the incremental value created is greater than the firm value & the premium paid.
  • Variance of firm value
  • Risk free interest rate

Example 1

Assume the following values

Book Value of net assets of LLC = 1,000,000

Market Value of net assets of LLC = 2,000,000

Personal tax rate = 40%

Termination of the LLC for tax purposes would result in a gain of 1,000,000. This would be taxed at 40%. Hence the option premium would be 400,000. It would make sense to exercise the option to convert to a regular corporation if and only if going the IPO route creates a value greater than 400,000.

The value of the option at inception can be calculated using the standard formulas for contingent premium options.

Reorganization Flexibility – Acquiring other firms

LLC is also an attractive acquisition vehicle. Assuming issues relating to valuation, currency and ownership structure are resolved an LLC can acquire an existing corporation by exchanging the stock of the target for ownership certificates in the LLC. The big attraction of this mechanism is that if structured correctly it will not result in a constructive sale on behalf of the seller avoiding associated gains and taxes.

Reorganization Flexibility – Selling to an Acquirer

On the opposing end, LLC is also an attractive target acquisition since it avoids one layer of corporate taxation. A step up in basis or recognition of gain is dependent on how the transaction is structured and whether the LLC continues in business. The layer of corporate taxation is eliminated since all proceeds from the sale pass through directly to the members and are taxed at their individual income tax rates.

Conclusion

We believe that a Limited Liability Company is an attractive form of organization for startup ventures. The biggest advantage of this form is the flexibility it offers. Although there are issues with recapture of losses, but as long as the issues and the stakes are understood, LLC can be create a lot of value by minimizing the tax impact for owners, buyers and sellers of a business.

cted Articles and Readings

  1. Fundamental of partnership taxation (4th edition). Stephen A Lind, et al

Includes useful reference to rules, case law and cases along with a review of taxation of partnership rules. Some information on LLC’s but primarily a text on partnerships and Chapter S corporations.

  1. The Small Business Legal Advisor (2nd edition), William A Hancock

One chapter on forms of business organization. Includes advice on taxes, payroll, lawyers, accountants, startup, etc

  1. Venture Capital: Law, Business Strategies and Investment Planning. Josehph W. Bartlett.

Review of organizations form and securities law

  1. IPO Value Journey, The Ernst & Young Guide. Stephen C Blower, et al

Very interesting & useful chapter on pre-IPO personal tax planning.

  1. Limited Liability companies, the choice for the future. Commercial Law Journal, Summer 1998, William H. Copperthwaite, Jr

Comprehensive review of LLC’s in less than 4 pages.

  1. The Swiss Army Knife of Planning… Financial Planning, July 1, 1998, Martin M. Shenkman

Comparison of organizational models and a review of LLC’s for financial planners

  1. Converting a Corporation to an LLC. The CPA Journal, March 1998, Jeffery Mark Borofsky

Review of some of the legal issues involved in converting a C / S Corp to an LLC.

  1. Significance of the “choice of entity decision” for business owners. Tax Advisor, Aug 1999. Ed Rgby
  1. The answers point to the LLC. The CPA Journal, Aug 1999, Peter A Karl III

Question answer format review of organizational forms.

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