LLC versus S Corp

Joseph W. Bartlett, Founder of VC

When an entrepreneur starts out, the basic threshold issue is whether to organize the start up firm as a C corporation, S corporation, or an LLC. There are a number of sources of information to help entrepreneurs in making this decision, as well as a number of factors to consider.

One of the principal problems with an LLC, however, is not generally appreciated outside the fraternity of active practitioners, including veteran lawyers and accountants. The fact is that an employee option plan (a "unit plan" in LLC parlance versus a "stock option plan") can be a nuisance if the issuer is a limited liability company. First, an LLC option does not qualify as an incentive (i.e., tax favored) stock option, and probably will not, even after conversion to a C corporation. Moreover, while the grant to an employee of an option to purchase LLC equity does not have an immediate taxable consequence for the LLC or the employee upon the exercise of such an option, several significant tax consequences appear likely. Although the issue is not free from doubt, once an employee acquires LLC equity, she is likely to be treated as a "partner" for tax purposes, entailing some significant tax consequences, namely:

  1. The employee's obligation to pay tax on her allocable portion of the LLCs income. This can entail taxable income without equivalent distributions. aka tax on "phantom income")
  2. The employee's obligation to make quarterly estimated tax payments rather than income tax withholding on wages.
  3. Liability for the full amount of employment taxes as a self-employed LLC member rather than the LLC bearing one-half of the employment taxes.
  4. Taxation (rather than exclusion) of certain fringe benefits such as group term life insurance and, more importantly, employer-provided health care insurance. (NB: For 1998, self-employed individuals could deduct 45% of the cost of health care insurance. For later years, the deductible portion will increase to 100% in 2007, under a schedule in the Internal Revenue Code §162(l).
  5. If the LLC equity includes a capital interest and there is unrealized appreciation in the LLCs assets, the transfer of the LLC equity may trigger taxation to the employee.

More importantly, exercise introduces a new partner to the entity that requires a "book up" for tax purposes, meaning a requirement to mark the LLC's assets to market. This can be very tedious, particularly if the LLC has to do so on each exercise, and the result is that the LLC maintains two sets of books.

One fairly straightforward solution is to forestall any option exercise until after the date the LLC converts to a C corporation in anticipation of an IPO, acquisition or merger. Options would "vest" under a schedule to be determined, but would not be exercisable until the "first exercise date." For option holders who leave employment prior to this first exercise date, the post-termination exercise period would continue until the conversion of the LLC. By extending the post-termination exercise period, no departing employee will feel compelled to exercise the option that would otherwise expire due to termination of employment. Preventing option exercises also will save the LLC the costs associated with accounting and reporting obligations to a holder of a relatively small interest in the LLC. It also simplifies the management of the LLC when membership votes are required.

Thus, the decision between corporation and LLC must take into account not only issues of flexibility or simplicity, but future tax consequences of key employees, as well. These deeper tax consequences must be considered up front, before the decision to incorporate is made.