Someone just raised an issue with one of my partners and I've never heard anyone else mention it before. Considering the possible implications I'm surprised that it isn't something that comes up all the time, so maybe this other person is mistaken. (I'm not a financial guy at all so bear with me as I try to explain this in my own words.)
There are four founders - one will hold the majority of the equity while the others are 10% each, for simplicity. So far we've each contributed what we could (or had to) in developing the new business idea (research, coding, travel, etc). We feel good about the market and how we can address it, and our financial projections are strong, but conservative.
We have been planning on creating an LLC first because that's quick and cheap, and leaves us more flexible if the business doesn't grow as quickly, or the way we expect. After forming the LLC we will be looking for $1.5 million as convertible notes. If all goes according to plan, in 12 to 24 months we expect to raise more money in a series A round, and at that point we would convert to a Delaware C Corp.
So far that sounds like the path many startups would take, right?
However, while looking at our financial projections someone mentioned that the LLC was accumulating losses, right up to the time of our series A round. Those losses in the LLC would be passed through to the four members of the LLC so we would each have a large negative capital account. On converting our LLC to a C Corp the founders would be hit with a big tax bill because the IRS will treat the previous losses (from the LLC) as a forgiveness of debt since we wouldn't be passing them to the new C Corp.
I understand that the LLC is treated as a partnership for tax purposes, so the profits and losses flow to the members. After all, one of the benefits of LLCs is that they avoid double taxation.
So is the tax hit a real issue? Is this other person just confused/wrong? If it is a potential problem, is there an obvious workaround that everyone else already knows about? Since we expect to raise more money in the future should we really spend more money on legal fees now to set up the C Corp from the beginning. (Cash is very tight and we would prefer to invest what we have in the new products and recruiting a few key people.)
I hope this question makes sense.