Entity Planning for Startups: 6 Questions to Ask Before Classifying as a C-Corporation or LLC
While seemingly a minor decision that many startups do not invest much time or planning into, the decision to start the company as an LLC or C-Corporation has some significant tax implications, both short term and long term. Below are several key differences between these two entity types to start the planning discussion for your startup company.
1. Who benefits from the startup tax losses?
The individual owners reap the benefits of the tax losses from the company, as LLCs are referred to as “flow-through” entities. Simple in concept, but much more complicated in execution, LLCs split their losses for the year based on some percentage, either a profit/loss percentage or a special allocation percentage, between the owners. The owners then report their share of the LLC losses on their individual tax return for the year. Depending on the tax basis rules and the tax passive loss rules, the owners may be able to deduct their share of the LLC’s losses against their other income sources for there. Which, then reduces their overall tax for the year. While the tax deductions are not a dollar-for-dollar offset to the owner’s tax, they do serve some immediate economic benefit to the owner versus waiting purely for an earn-out event or dividend in the future.
The company itself benefits from the tax losses generated during the year. This is because C-Corporations are their own taxable entity in the eyes of the IRS, so the company is subject to tax at the entity level. If the company generates a loss, then the company does not pay any tax that year. It’s important to note that this applies to Federal tax and many states. However, some states do have minimum tax amounts that are assessed regardless of profitability.
In years in which the company generates tax losses and does not utilize them in that year, those losses generate a “Net Operating Loss.” Those losses can then be carried-forward to the next year to offset a future year’s taxable income. If there are multiple loss years in a row, the losses compound on each other year-over-year to create a larger Net Operating Loss to be utilized once the company is profitable.
2. Are the owners subject to yearly tax reporting with an ownership interest in the entity?
Due to the flow-through nature of an LLC, the owners are subject to yearly tax reporting due to their ownership interest in the LLC. This reporting is done by way of a “Schedule K1” from the LLC to the owner. The K1 is how the company reports each owner’s share of profit or loss for the year, as well as many “separately stated” income and deduction items from the company. Since the K1 is needed to file the owner’s individual tax return for the year, the owner will have to wait for the company’s tax return to be completed for the year, as the K1s are prepared with the company’s tax return for the year. In other words, the K1s are not stand-alone forms that can be prepared ahead of the company tax return like an employee’s W2 Form can.
Since C-Corporations are their own taxable entities, the owners are not subject to tax on the C-Corporation’s taxable income for the year, just as the owners do not benefit from the C-Corporation’s losses for the year. There is no additional tax reporting from the C-Corporation to the owner for the year, which means owners of C-Corporations do not have to wait for the C-Corporation tax return to be filed in order to file their individual tax return for the year. The only caveat would be if the C-Corporation issues dividends to the owners, or pays the owners wages for services provided to the company. If either of these applies, the C-Corporation will issue the owner a 1099-DIV for dividends or a W2 for wages. These are required to be issued by the end of January, so they do not hold up the owner’s tax return any more than any other tax forms for the year, such as bank 1099 forms, home interest 1098 forms, investment tax statements, etc.
3. Who pays the tax once the company becomes profitable?
Just as the owners benefit from the tax losses from the LLC, they are also responsible for paying the tax on the company’s taxable income for the year. Most owners are shocked to hear this, as why would they have to pay the tax on the company profit? While on the surface this seems counterintuitive it actually works to tax the company profit only one time, at the owner level. Since the owners are paying tax on the company income, most LLCs will make cash distributions to the owners to pay the tax. These are simply called tax distributions, and effectively make it that the company is using its cash to pay its tax. It just requires the tax to be reported by the owner, who is then given company cash to pay the tax.
Just as the company benefits from its tax losses, it also pays the tax in profitable years. As such, there is not the need to pay tax distributions to the owners because their tax returns are not impacted by company tax profit.
4. Does double taxation apply?
Aside from states that that have state-level LLC tax, an LLC is not subject to double taxation the Federal level. This is the scenario in which the company pays tax on its profit, and then the owners pay tax on their cash distributions from the entity. For an LLC owner, as long as they have “tax basis” in their cash distributions, they do not pay additional tax on those distributions. Profitable LLCs only pay tax on the profit one time, which is done at the owner level.
C-Corporation profit, when paid out to the owners as dividends, is taxed two times. The first time is when the company pays tax on its profit for the year. Then, a second time when the owners are paid a dividend for the year because the owners are subject to tax on their dividend payments from the company. There are favorable tax rates for certain types of dividends, however, tax does apply still. As such, profitable C-Corporations that pay out dividends every year are subject to double tax.
5. What is the tax impact of selling ownership?
When selling an LLC interest, the owner’s gain on the sale is subject to tax on the gain. The gain is the total sales proceeds less the owner’s tax basis in the ownership interest. While, there are some scenarios in which some of the gain could be subject to ordinary tax rates, the hope in selling an LLC ownership interest is for capital gains tax rates to apply. If the ownership interest is held for over a year, then the favorable long-term capital gains rates would apply. This gives the LLC owner an effective tax break on selling the LLC ownership.
As with an LLC, when a C-Corporation ownership interest is sold, the sale is subject to tax on the gain on the sale. The gain is calculated similarly to an LLC ownership interest sale in which the proceeds less the owner’s tax basis in the ownership interest. The gain would be subject to capital gains tax rates, and would get the favorable long-term capital gains rates if the ownership is held for over a year.
6. Are there tax benefits when selling ownership?
For LLC owners, aside from long-term capital gains tax treatment if ownership is held for over a year, there are no extra tax benefits at the point of sale for LLC ownership.
For C-Corporation owners, there is a significant tax benefit for owning Qualified Small Business Stock, which is stock of a qualifying small business corporation. If the owner holds their stock for at least five years, they can sell the stock and avoid paying tax on the first $10,000,000 in gain on the stock. This could even be higher depending on the amount they purchased their stock for, but they would at least get to exclude the first $10,000,000. At a 30% tax rate, which is not uncommon when Federal capital gains tax, Net Investment Income Tax, and state tax apply, that would be a $3,000,000 tax savings. This can be a huge tax benefit and incentive to invest in C-Corporations that are Qualified Small Businesses.
If the Qualified Small Business Stock is sold within five years, then the tax gain exclusion is lost. However, if those proceeds are used to purchase new Qualified Small Business Stock, then the gain on the sale of the first stock is deferred until the new stock is sold. While this does not give the owner the permanent gain exclusion, it does allow the owner to “serial invest” from one Qualified Small Business into the next.
While there are some other subtle tax differences between the two entities, we highlighted the most significant tax differences between an LLC and a C-Corporation. As with any company structural decision, there is not one of the above factors that should be the sole decision point for deciding between LLC and C-Corporation for your startup company. A planning discussion around all of these factors, as well as the legal implications of each entity, should be engaged in prior to determining the legal entity type for your startup. For more information on this planning area, or for assistance in determining your entity type, please contact an Anders startup advisor.