LLC versus Corporation for Equity Crowdfunding

June 22, 2012

The traditional debate for promoters of start-ups when choosing which entity to utilize has been confined to three (really four) choices; sole proprietorship/partnership, S-Corp, or LLC. In most instances, each of these forms has allowed for initial losses to be passed through to the individual tax return(s) of the ownership to offset other sources of income and provided a single level of taxation on when the business became profitable, again thanks to the pass-through taxation of these choices, so the only real questions were limited liability versus unlimited liability and the reduction of employment taxes.

Start-ups which capitalize in whole or in part through utilizing equity crowdfunding have a whole other array of factors which must be carefully considered when choosing which form of business entity to utilize.

Sole Proprietorships

Since the very definition limits the ownership of a sole proprietorship to an individual (or husband and wife who file taxes jointly), investors of any kind, including equity crowdfunding investors, are not an option.

Partnerships

Partnerships come in two varieties outside the realm of professional business associations run by attorneys, accountant, and architects; general partnerships and limited partnerships.

General Partnerships

A simple explanation of general partnership is two or more owners who conduct business as co-owners and manage under the theory of mutual agency (in which each partner is an agent of the others), and each partner has joint and several liability for all the liabilities and judgments against the partnership (read, total liability for everything).

Needless to say, no business promoter in their right mind would capitalize through equity crowdfunding and take on complete strangers are general partners.

Limited Partnerships

A limited partnership is similar to a general partnership, but must have at least one general partner and at least one limited partner. Limited partners do not manage the partnership and their liability is limited to their initial investment (so long as they do not act as general partners by participating in management). The general partners, however, are subject to joint and several liability (read, total liability for everything).

While it is plausible that there are circumstances in which a limited partnership might be utilized as a business entity which is in part capitalized via equity crowdfunding, there are other options which do not include joint and several liability for management.

S-Corps

While the S-Corp is my entity of choice for an actively operated business, it is highly unlikely to be available as a choice for use in a business capitalized through equity crowdfunding because its use is limited to 100 shareholders. The idea of equity crowdfunding is to take small investments from a large number of people, therefore, unless the amount to be raised from the investors is small or the share price very high, use of the venerable S-Corp is probably out of the question.

Limited Liability Companies

Using an LLC is a valid choice as an entity to utilize for a business capitalized using equity crowdfunding.

The Pros

Unlike a limited partnership, an LLC provides liability protection from third-party claims for management and investors alike. Also like a partnership, it provides for pass-through taxation which in general is a financial advantage.

The Cons

One downside to using an LLC is that it is not conducive to large turnover in ownership. Although variable from jurisdiction to jurisdiction, too much ownership change volume may force the dissolution of an LLC. In addition, and members of an LLC must vote to admit new members to an LLC (when a membership is sold, it becomes an economic interest unless existing members vote to admit the holder of an economic interest as a member). Under the JOBS Act, securities purchased through equity crowdfunding may be resold one year after issuance. While it remains unclear whether or not a secondary market will develop in which securities initially sold via equity crowdfunding will be actively traded, the time and expense to management of facilitating voting on newly admitted members could very well overshadow the financial benefits sought.

Another detriment of using an LLC comes at tax time. It is entirely possible (and in fact, typical) that the members of an LLC receive K-1s indicating the members’ share of the profits of the LLC exceed the actual amounts distributed. While less common, it is entirely possible for the tax liability of a member for the profit of an LLC to exceed the actual amount distributed. Accredited investors are accustomed to this when it occurs and at least in theory are capable of absorbing such costs. Equity crowdfunding investors may be less sophisticated financially and may question or doubt the validity of such an occurrence, and some may be unable to absorb any tax liability in excess of amounts distributed.

Corporations

A corporation is also a valid choice as an entity to utilize for a business capitalized using equity crowdfunding.

The Pros

Like LLCs, corporations provide liability protection from third-party claims for management and shareholders alike. Since corporations are subject to double taxation (income tax paid at the corporate level and capital gains tax paid on dividends at the shareholder level), shareholders will only be taxed on the dividends they actually receive. The taxes paid by shareholders as of the date of this writing is 15% if the dividend is classified as qualified.

The Cons

While double taxation may easier for investors, in general it means that more taxes are being paid and in turn investors are reaping less financial benefit from their investment.

Another negative for the use of a corporation is the requirement to hold annual shareholders meetings. While the JOBS Act creates a simplified form of financial reporting to the SEC and only stipulates such reporting must be shared with investors who acquired securities through equity crowdfunding, and while the JOBS Act specifies that equity crowdfunding pre-empt state (blue sky) securities laws, the JOBS Act does nothing (nor should it!) to modify the general corporate law of each state. While bylaws may be carefully drafted to ensure that means of electronic communications are not offered for purposes of holding shareholders meetings (that would be one heck of a Skype session!), and presumably most equity crowdfunding investors would not travel far to attend a meeting of shareholders, it is conceivable that thousands of people could show up for a meeting of shareholders, which means at worst you need to pay for somewhere to meet, and at best you will have to pay for the printing postage of thousands of meeting notices and ballots each year.