LLC Raising Money: SAFEs, Selling Units and Investor K-1s

Can an LLC raise money without converting to a corporation?

Yes. An LLC taxed as a partnership can sell new units to investors, and cash paid to the LLC for those units is generally not taxed to the LLC or its members (26 U.S.C. 721(a)). Nothing in the tax rules requires a corporation to take investor money.

What raising in the LLC costs is ongoing work, not a one-time tax:

A case is not simple when a single-member LLC takes its first investor, when the money comes in as a SAFE or note (the tax treatment is unsettled), when an investor is foreign or tax-exempt, or when a later move to a corporation is likely. Converting later is possible but has its own tax steps; see moving a startup into a Delaware corporation.

Gather the operating agreement, each member's capital contributions to date, the term sheet or SAFE, and a supportable current value of the business.

Selling units in an LLC to investors: is the money taxable?

Cash paid to the LLC for newly issued units is generally not taxable to the LLC or to the existing members. Section 721(a) says no gain or loss is recognized to a partnership or any partner on a contribution of property for a partnership interest (26 U.S.C. 721), and the IRS applies that to an investor's cash (Rev. Rul. 99-5).

The answer flips in four cases:

• The investor buys a member's existing units. That member is selling, and gain or loss is recognized to the selling member (26 U.S.C. 741).
• The LLC passes the investor's cash on to existing members. A contribution paired with a related payout to another member can be treated as a sale between them (26 U.S.C. 707(a)(2)(B)).
• Units are given for work, not cash. Section 721 covers contributions of property; an interest received for services follows other rules. See splitting ownership between LLC partners.
• The LLC would be an investment company if incorporated. Section 721(b) removes the shelter for that gain; this rarely fits an operating startup but is worth checking for a holding LLC.

What changes when a single-member LLC takes its first investor?

A single-member LLC is disregarded for tax by default, and it becomes a partnership the day it has a second member (Treas. Reg. 301.7701-3(f)(2)). From that day the LLC files Form 1065 and issues K-1s; activity before that day stays on the owner's own return. Because the owner is treated as contributing the LLC's assets, the owner's capital account starts at their fair market value, not at what the owner put in (Treas. Reg. 1.704-1(b)(2)(iv)(d)).

How the deal is written decides who is taxed. Rev. Rul. 99-5 sets out both cases:

Can an LLC issue a SAFE or convertible note?

An LLC can sign a SAFE or convertible note, but the tax treatment of a SAFE issued by an LLC is unsettled. The IRS has not published guidance that classifies it. The nearest rules are the partnership option regulations, which cover warrants, convertible debt and similar rights to acquire an interest (Treas. Reg. 1.721-2(g)).

If a SAFE is treated as an option under those regulations:

• When it is issued, section 721 does not govern the cash paid for it; general tax rules do (Treas. Reg. 1.721-2(b)).
• When it converts into units, section 721 generally applies, so conversion is generally tax-free to the LLC and the holder (Treas. Reg. 1.721-2(a)).
• If it lapses or is settled in cash, section 721 does not apply and general tax rules decide the result (Treas. Reg. 1.721-2(c) and (d)).
• The holder can be treated as a member before conversion if the instrument gives partner-like rights (such as current distributions or a share of losses), or is reasonably certain to convert, and there is a strong likelihood that treating the holder as a non-member would substantially reduce the members' and holder's combined tax (Treas. Reg. 1.761-3).

A convertible note is convertible debt under the same rules. Units issued for accrued interest on the note are not covered by section 721 (Treas. Reg. 1.721-2(e)).

A single-member LLC that issues a SAFE generally stays disregarded until the SAFE converts, unless the SAFE is itself treated as a partnership interest under these rules or general tax principles (Treas. Reg. 1.761-3(b)(2)). If the founders expect to convert to a corporation before the SAFE converts, decide the order first; see moving a startup into a Delaware corporation.

What are capital accounts, and why are they restated when an investor comes in?

A capital account is each member's running share of the LLC's equity: it goes up for cash and the value of property contributed and for income allocated, and down for distributions and losses allocated (Treas. Reg. 1.704-1(b)(2)(iv)(b)). In an agreement built to the regulations, liquidation proceeds follow positive capital account balances (Treas. Reg. 1.704-1(b)(2)(ii)(b)).

A new investor pays today's value, but the founders' accounts show only what they put in. The regulations let the operating agreement restate every member's account to fair market value when a new or existing member contributes more than a de minimis amount, or when the LLC issues an investor option such as a warrant (Treas. Reg. 1.704-1(b)(2)(iv)(f)). This restatement is often called a book-up. Without it, gain built up before the investor arrived can later be shared with the investor.

A book-up changes no one's tax at the time. The built-in gain stays with the founders for tax under section 704(c) principles, which the agreement must require. When the K-1 reports capital in item L, it uses a tax basis, so it will not match the restated book account; item N shows each member's share of unrecognized built-in gain, including gain from revaluations (Form 1065 instructions).

What will each investor get each year: a K-1, and possibly a state K-1?

Each investor gets a Schedule K-1 showing that member's share of income, loss, deductions and credits. A calendar-year LLC must file Form 1065 and furnish K-1s by March 15, or September 15 with a timely extension (Form 1065 instructions).

The investor owes tax on that share whether or not the LLC distributes any cash (K-1 instructions). Losses pass through too, but the investor's use of them can be limited by basis, at-risk and passive activity rules.

A late Form 1065 costs $260 per member per month, for up to 12 months, so each new investor raises the penalty.

If the IRS later adjusts a past return, the LLC itself generally pays the tax in the year the adjustment is made, so a new investor can bear the cost of years before joining, unless the LLC elects within 45 days of the final notice to push the adjustment out to that year's members (26 U.S.C. 6225, 6226). Only a small partnership whose members are all individuals, corporations or estates can elect out of these rules each year; one with a fund organized as a partnership among its members cannot (26 U.S.C. 6221(b)).

States add their own layer. California, for example, requires an LLC organized, registered or doing business there to file Form 568 with a Schedule K-1 (568) for each member, and to pay an annual tax and, above a revenue level, a fee (California FTB). Other states have their own partnership returns and rules for nonresident members.

Tax distributions for LLC investors: what are they, and who decides?

A tax distribution is cash the LLC pays members so they can cover tax on income allocated to them. It is a term of the operating agreement, not a tax rule: nothing in the tax law requires one, because the members, not the LLC, generally owe the income tax.

Investors ask for them because the K-1 income is taxable to them even when no cash comes out (K-1 instructions). The operating agreement should state:

• the assumed tax rate and whether it is the same for every member;
• whether earlier losses reduce the income used in the formula;
• when payments are made (often around estimated tax dates) and whether they are advances against later distributions;
• what happens if the LLC lacks cash or a lender restricts payouts.

Counsel drafts these terms; the accountant computes the amounts from the allocations each year.

LLC vs C corp for raising capital: why do venture funds often decline LLC units?

Many venture funds have partners whose tax position makes an operating LLC costly to hold, and an interest in an LLC taxed as a partnership cannot be qualified small business stock.

This is why investors often ask the LLC to convert before they invest. Withholding for foreign members is covered in foreign partners and withholding; whether an LLC can ever reach qualified small business stock is covered in LLC or C corporation.

Can the LLC elect to be taxed as a corporation instead?

Yes. An LLC can file Form 8832 to be taxed as a corporation while staying an LLC under state law. For a multi-member LLC, the election is treated as the partnership contributing all its assets and liabilities to a new corporation for stock, then handing that stock to the members (Treas. Reg. 301.7701-3(g)(1)(i)).

The election date can be set no more than 75 days before filing or 12 months after it, and a further change is generally barred for 60 months (Treas. Reg. 301.7701-3(c)). The election changes tax treatment only; it does not give investors Delaware corporate stock. For a missed or late election, see late LLC election relief; for a full move, see moving a startup into a Delaware corporation.

Example

These examples are illustrative; all figures are in US dollars.

A single-member LLC sells a fifth to an angel

A founder's single-member LLC agrees to give an angel 20% for $250,000.

• The angel pays the LLC for new units: the LLC becomes a partnership on the closing day. Neither the founder nor the angel recognizes gain at closing. The founder reports the LLC's results up to closing on the founder's own return; the LLC files Form 1065 for the rest of the year and issues two K-1s. The founder's capital account starts at the $1,000,000 value of the LLC's assets, not at what the founder put in.
• The angel pays the founder for existing units instead: the founder is treated as selling 20% of each LLC asset and may owe tax on that gain. The $250,000 goes to the founder, not the business.

Book-up when an angel joins a two-founder LLC

Two founders' LLC is already a partnership. Their capital accounts total $10,000, equal to the tax basis of the LLC's assets. An angel pays $250,000 for 20%, which values the business at $1,250,000 after the money and $1,000,000 before it. The operating agreement books up: the founders' accounts are restated to $1,000,000 in total and the angel's starts at $250,000. If the LLC later sells its business assets for $1,000,000 and keeps the angel's cash, the books show no gain to split, so the angel does not share in value built before the angel arrived. For tax, the $990,000 gain is allocated to the founders.

A loss year, then a profit year

• Year 1: the LLC loses $400,000. The angel's K-1 shows an $80,000 loss, which the angel may or may not be able to use under the basis, at-risk and passive rules. No tax distribution is due.
• Year 2: the LLC earns $500,000, and the angel's K-1 shows $100,000 of income either way. A tax distribution at an assumed 40% rate depends on the formula: if the agreement nets earlier losses, it is based on cumulative income of $100,000, so $8,000 to the angel and $32,000 to the founder; if not, it is based on the year's $500,000, so $40,000 to the angel and $160,000 to the founder. The agreement, not the tax law, decides which.

Different for you?

• Investors want a Delaware C corporation: see moving a startup into a Delaware corporation, and get startup tax help before signing.
• You are still choosing between an LLC and a C corporation: see LLC or C corporation.
• One member funds and another works: see splitting ownership between LLC partners.
• An investor is foreign: see foreign partners and withholding and get startup tax help.
• You meant to elect corporate tax treatment and it never took effect: see late LLC election relief.
• The money came in as a SAFE or note, or a book-up was never done: the treatment depends on the instrument and the agreement; get startup tax help.