LLC Choice of Entity for Emerging Technology Companies

The recent $1 Billion Qualifying Therapeutic Discovery Project Credit program will be a real benefit to many area small life science and medical device companies. A surprise to many though when reading the requirements of the program is that limited liability companies (LLCs) that have as an owner a tax-exempt organization are not eligible for a grant under the program. Having a tax-exempt organization as an owner is more common than one might think. Many university technology transfer offices, such as the Wisconsin Alumni Research Foundation (WARF), are tax-exempt organizations and frequently hold an equity interest in the startups to which they license patents. As a result, those LLC biotech licensees are not eligible for a grant under the program. As the CEO of an LLC with which I work (but did not set up) said earlier this week about being excluded from eligibility, “Ouch! That stings! Another painful learning experience.”

LLCs are Typically Not the Best Choice of Entity for Emerging Technology Companies

The “LLC issue” for emerging companies extends well beyond this grant issue for therapeutic companies. I say this even though many attorneys recommend LLCs for virtually all contexts. Sure, LLCs have their place. I frequently advocate using them as holding companies, investment vehicles, and joint venture entities. Among other situations, it also can be appropriate to use them when there is a limited, small group of owners actively participating in the business or when the owners want to have a certain allocation of profits and losses that cannot be accomplished when using an S or C corporation. But for many emerging companies that have or plan to have outside investors, the LLC is often not the best choice of entity.

Most people have a general understanding of the potential benefits of LLCs: pass-through tax treatment, flexibility, few formalities, ease of setup, etc. I will leave it to others to summarize in detail the benefits of LLCs, as there are many.

The “I didn’t know” LLC Issues for Emerging Technology Companies

What I often encounter is that an “issue” arises after the founders either worked with a drumbeating LLC advocate when they were initially organized or the founders organized the entity themselves through an easy-to-use website. In either case, frequently, the founders do not have a good understanding of the common issues that arise through the life cycle of the entity. These “I didn’t know” issues come up often after the company has been operating as an LLC for a while. Below is a list of some of the LLC issues that I have witnessed:

  • A 10% owner of an LLC becoming a less than 1% owner of a corporation after conversion to a corporation because his capital account in the LLC was propotionately less than that of the other owners.
  • A venture capital firm refusing to look past the heading of an executive summary after it discovers the entity is set up as an LLC.
  • Spending tens of thousands of dollars (not to mention management and investor time) implementing and maintaining “blocker corporations” to limit unrelated business taxable income (UBTI) to the VC firms’ limited partners, while trying to maintain economic parity between investors, through several rounds of venture capital financings.
  • “What do you mean I can’t take advantage of the losses because I don’t actively participate in the business?!?”
  • A small, dissident group of members refusing to consent to a conversion, which in many states requires a unanimous vote of LLC members.
  • Inability to take advantage of the special tax benefits of incentive stock options available to corporations.
  • Spending several dozens of hours more than it would take to administer a stock option or restricted stock program to administer a profits interest program.
  • Two members of an LLC (with negative capital accounts) owing taxes as a result of converting to a corporation.
  • Significantly higher investment transaction costs as law firms generally do not have “standard” LLC investment documents for sophisticated transactions.
  • When a company started to make money, requiring the owners to choose between receiving “phantom income” or making distributions to members to cover individual taxes at high marginal rates, despite a desire to reinvest that cash and grow the company.
  • Inability to do a tax-free reorganization as an exit strategy.
  • An LLC taking 5 months to obtain the required residency certifications and tax information authorization forms from each of its 78 members in order to limit the international tax withholding requirements in connection with a transaction.
  • An LLC obtaining the required written authorizations and powers of attorney of 90+ nonresident members in order to file consolidated state tax composite returns in 8 states (and the corresponding K-1’s from each state sent to each member).
  • Spending tens of thousands of dollars (attorney and accountant fees) converting to a corporation

I could go on and perhaps dedicate a post to each of these situations. And, of course, there are expensive and complicated solutions to some of these issues. But as some of my former colleagues at Michael Best said in a recent article, choosing an LLC can be a mistake for many companies and the decision should not be made without a full understanding of the ramifications.

Converting an LLC to a Corporation

A frequent comment I hear from executives of companies that are set up as LLCs is that they can convert to a corporation at any time. This is generally true. With the exception of some of the issues I described above, it often just involves an analysis of the benefits of being a corporation versus the time and expense involved to convert to one. I have handled a number of conversions and co-authored a brief post on the topic: Changing Your Choice of Entity: Cross-Species Mergers and Conversions. The difficulty is that the longer a company waits and the more complex the company’s capitalization structure, the more expensive it is and the longer it takes to do.

As with most important decisions, it is wise to talk with your trusted advisors about choice of entity issues. Take the time to understand the potential (and likelihood) of the benefits and costs long term, especially if you are considering using an LLC as the entity for your emerging growth company. Sometimes an LLC is the best entity choice, but more often for emerging technology companies, it is not.

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