Whether at 7-11 or at your local grocery chain, functional beverages line the aisles, touting their nutritional and health benefits. The functional beverage industry is becoming big business, but as this industry bubbles up, emerging brands need to think about the best corporate structure to hold their product.
Below, we have provided some pros and cons of three (3) standard corporate structures often considered by early-stage businesses: limited liability companies, S corporations, and C corporations.
LLC: The Smooth Operator
A limited liability company (LLC) is a corporate structure well known to most, and it has proved beneficial to many in the CPG industry. Generally, LLCs provide for greater management and organizational benefits. For example, if there are multiple partners involved in the development of a functional beverage product, an LLC structure makes it easy to classify the role, ownership, and management responsibilities of each individual. This can be done at formation of the LLC, by delineating the duties and powers of each individual in the company’s operating agreement, allowing for more clarity and division of responsibilities.
As a default, an LLC with more than one owner is taxed as a partnership (i.e., a pass-through entity for tax purposes). This means that the LLC’s profits and losses are allocated annually among its members and each member includes his or her respective share of those tax items on his or her income tax return (whether or not the LLC makes distributions to the members). Because the LLC is a pass-through entity for tax purposes, the LLC’s income is not subject to double taxation. Double taxation is the imposition of taxes on the same income at two different points of time, once at the entity level and then again at the member/investor level (in the form of a distribution of profits or upon sale of the entity). Historically, the biggest tax benefit for profitable brands is that the owners generate a higher after-tax return by only being subject to a single layer of taxation (compared with operating through a C-Corp). However, with the reduction in the corporate income tax rate to 21% as part of the 2017 Tax Cuts and Jobs Act (TCJA), there may not be as significant of an after-tax benefit by operating through an LLC.[1] Another added tax benefit is that an LLC has some flexibility in how it allocates taxable income among its members (compared to an S-Corp).
LLCs also offer added protection for an owner’s assets because of their classification as separate legal entities, meaning that creditors of the company cannot go after the individual owner’s assets. Any new industry is risky, but especially in the CPG industry. By opting to form a LLC to hold their brand, entrepreneurs will receive an added level of protection for their personal assets because owners, generally, cannot be sued for the actions of the employees or other members of the LLC (except in rare situations where owners fail to maintain a clear separation between their personal finances and the business, fraud, or instances of personal guarantees).
The downside? Raising capital can be tricky. Many early-stage brands anticipate needing to raise capital to expand their operations. Notably, the benefits of pass-through taxation and management structure (discussed above) are typically not attractive to investors. Investors traditionally like to put money into start-ups at a discounted price, whether through convertible notes, a Simple Agreement for Future Equity (SAFE), profits interest, or a different business loan or grant basis. In doing so, the primary benefit arises from being able to purchase “preferred” shares of an entity, which will be valued at a higher price in the future. Some of these common early-stage fundraising documents (such as SAFEs) are also reserved for corporations. Additionally, tax-exempt and non-US investors (and private equity/venture capital funds with such investors) are deterred from investing in LLCs due to certain tax complications.
Notably, ownership of a membership interest in an LLC does not qualify for ‘Qualified Small Business Stock’ (QSBS) benefits (see C-Corp discussion below).
Brands should weigh the pros and cons of an LLC structure, as converting an entity to a C corporation prior to fundraising can be an expensive endeavor and pose additional regulatory and legal requirements. Although the LLC is a great structure for a many early-stage brands, entrepreneurs should heavily consider the implications on future fund-raising opportunities as well as the inability to qualify for QSBS benefits.
S-Corp: The Structured Sip
An S Corporation (“S-Corp”) is a close relative of the LLC, as it provides the same pass-through taxation benefits and limited liability protection of the owner’s personal assets. Although LLCs are simpler and more flexible to maintain, a S-Corp provides a separate set of benefits, described below.
Because of its status as a corporation, the management of the S-Corp can be much more complex and individualized than an LLC. S-Corps may have multiple layers of governing bodies, such as shareholders that own the company, a board of directors that are the decision-making body, and officers who manage the day-to-day affairs of the company. This more in-depth structure allows companies to incorporate various levels of management and allocate power to certain individuals. On the tax level, functional beverage businesses have the option to structure the payment to themselves as employees and shareholders of the S-Corp as both a salary and dividend, allowing them to optimize after-tax returns (e.g., by minimizing employment taxes).
The biggest drawback to an S-Corp is the stringent set of tax rules regarding ownership and distribution. Most notably, an S-Corp may only have 100 shareholders. Generally, only US individuals and resident aliens can be shareholders, with some exceptions for certain charitable organizations, estates and trusts (including a revocable trust of the type often set up by individuals for tax planning purposes). These strict shareholder requirements restrict an S-Corp’s ability to grow without first undergoing a restructuring.
S-Corps also have strict ownership restrictions, limitations on the amount of losses that can be deducted based on an investors’ investment amount, and no flexibility in allocating taxable income, making them less attractive investment opportunities for investors. As a matter of law, stock of an S-Corp does not qualify for QSBS.
Although S-Corps allow for a more sophisticated corporate structure, early-stage brands should strongly consider the impact that this corporate structure may have on the future growth of their brand.
C-Corp: The Classic Choice
A C corporation (“C-Corp”) structure is often utilized by more advanced companies. Providing the same limited liability protection of personal assets as an LLC and S-Corp, the C-Corp differs in its governing structure and tax requirements. C-Corps allow for the same multi-level of governance as provided by the S-Corp, but generally the management of the company involves stricter compliance requirements, including more oversight by the governing bodies, stricter management, and more record-keeping and corporate formalities. Typically, these issues all amount to higher operating costs. However, unlike an S-Corp, there are no restrictions on the number or type of shareholders, which makes the C-Corp structure more advantageous for a growing company. The offset of greater capital costs associated with a C-Corp is that C-Corps are generally the most preferred corporate structure for outside investors.
The C-Corp structure generally result in profits being subject to double taxation because profits are taxed once at the corporate level, and then are subject to tax again once distributed to shareholders/investors (i.e., in the form of dividends or upon disposition of the stock of the C-Corp). Although not advantageous to many early-stage brands, C-Corps offer more tax benefits as the business grows. Generally, a C-Corp is taxed at a flat 21% federal corporate tax rate (under current law) and a C-Corp may qualify for additional tax deductions that otherwise would not be available to an LLC or S-Corp. So as the business continues to develop, the advantages of a C-Corp grow.
If shares of a C-Corp satisfy the QSBS requirements, shareholders can avoid paying federal income taxes on up to 100% of capital gains generated upon the sale of C-Corp shares. There are numerous requirements to qualify as QSBS, including, but not limited to, (i) a minimum holding period of five years, (ii) shares of the entity are issued by a C-Corp with no greater than $50 million in gross assets at the time of issuance, and (iii) shares of the entity are held by a noncorporate taxpayer, i.e. meaning any taxpayer other than a corporation.
A C-Corp allows for investors to easily buy and sell shares, making it significantly easier to raise capital from venture capital and private equity firms. A major advantage of this is when new producers pitch their functional beverage, the favorable entity and investors will be more willing to invest into the business. A greater growth of capital will effectively help develop the functional beverage faster.
While there is no straightforward answer as to the best legal structure for functional beverage brands, Husch Blackwell’s team can help your business determine the ideal corporate structure to meet your short-term and long-term goals. Contact Megan Beebe for more information.
[1] Under the 2017 TCJA, the corporate federal income tax rate declined from 35% to 21%. However, a provision was enacted to permits members of LLCs that operate non-service trades or business to deduct up to 20% of qualified business income from the member’s taxable income.