By Ralph Turlington
The corporate structure of a startup is something that can easily get overlooked when considering an investment opportunity. Currently, the two most common business entities are the LLC and the C Corporation. There are also S Corporations that have elements of each; however, they are quite rare when it comes to startups since the creation of LLCs.
Both LLCs and C Corporations provide investors with limited liability protection. This is one of the most important aspects of incorporating. Limited liability protection will ensure that creditors cannot claim any assets beyond the value of the investor’s investment in the company. Additionally, both LLCs and C Corporations allow centralized management where a small group of insiders may control the affairs of the business. The primary difference between LLCs and C Corporations is in their tax treatments. Both the pros and cons of these structures will be discussed in depth below.
LLCs are treated as partnerships and its members (the owners) are considered partners. As such, an LLC is not subject to tax on its income. It is known as a “flow-thru entity”, meaning its income and deductions generally flow through to the LLC’s members. So if the LLC has taxable income, its members pay the tax on that income at their top marginal rate. If it has a loss, as it generally will have in the early stages of a business, the loss flows through to the members and may shelter their unrelated income. There are, however, several limitations on the members’ use of LLC losses to shelter their other income, particularly for members who are not active in the LLC’s business activities and in situations in which a member’s losses exceed their personal investment in the LLC. If an LLC is used in the later years of a business, it won’t owe tax on profits or gains from the sales of its assets since all income and gains flow out to the members who owe the tax on their personal taxes.
There are some disadvantages of LLCs in comparison to C Corporations. One of the largest is the loss of the potential benefits of Sections 1045 and 1202 to the members of an LLC. Tax-exempt shareholders (like IRAs) may be taxed on income from a business set up as an LLC when that business becomes profitable. Even if little or even no tax is owed, tax-exempt investors may have to file tax returns. Out-of-state members of an LLC may have to file state income tax returns – and may even owe tax – in any state where the LLC conducts business.
Startup C Corporations
C Corporations are not flow-thru entities for income tax purposes. Instead, they and their shareholders are considered to be separate taxpayers. Out-of-state shareholders don’t pay tax on the corporation’s income. This means out-of-state investors don’t have to file non-resident tax returns. Tax-exempt shareholders (like IRAs) are not taxed on income or distributions from a C Corporation. There may be major tax benefits available to investors in C Corporations if the start-up is successful. Sections 1045 and 1202 allow for investors in a start-up structured as a C Corporation to either defer or exempt a large portion of tax which otherwise would have been owed. It’s important to note that Congress must re-enact these provisions for future years as they’ve done previously. Both of these sections are discussed in more detail below:
- Section 1045 of the Internal Revenue Code allows shareholders in the typical start-up to defer their tax on any otherwise taxable gain on a sale of stock held at least six months by reinvesting the proceeds in another small business C Corporation. The gain is taxed only when the reinvestment stock is sold. There is no dollar limit on the tax that may be deferred.
- Section 1202 of the Internal Revenue Code allows shareholders of a typical start-up to claim complete tax exemption on up to $10 million of gain on any otherwise taxable sale of stock in a qualifying C Corporation – as long as the stock has been held at least five years. Unlike Section 1045, no reinvestment in another corporation is required. This can be an enormous tax benefit, primarily to start-up entrepreneurs in successful C corporations.
There is an associated cost to the benefits of a C Corporation – a double tax regime. If the C Corporation has taxable income from business revenue or gains from sales of assets, the corporation pays tax on that income or gain at rates of up to 35% – plus applicable state income taxes, generally 8.84% in California. If it distributes that income or gain to its shareholders as dividends, there is a second layer of income tax imposed, this time on the shareholders at their top marginal rates. The combination of corporate and shareholder taxes on distributed income can result in total taxes exceeding 50%. If a C Corporation sustains losses, those losses remain with the corporation. They may be carried back or carried forward to shelter the corporation’s income in other years.
So what should angel investor be looking for? For an angel investor who will not participate in the operations of the company a C Corporation is often best. It allows for possible tax benefits under both Sections 1045 and 1202 of the Internal Revenue Code -– pending re-enactment. Additionally, it allows for different classes of shares to be sold to investors who fund the company at different times throughout the fundraising cycle. It is a good idea for any angel investor to ask what corporate structure a startup is using, and if they have any future plans to change.
(Disclaimer: This article is meant to provide a simplified overview of a complex legal topic. It involves some interpretation and by no means shall be considered legal advice.)