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Structuring a start-up business
Although setting up a new entity is usually quite easy, corporate structure and tax considerations play a fundamental role in a startup’s ability to raise capital. Potential investors have expectations about how a “venture capital risky” company (that’s to say, a business with the potential to generate significant returns with a potentially high valuation) must be organized under state law and filed for income tax purposes. However, the fundamental question for founders is: what
Actually makes the most sense for the business? Here, we briefly discuss four structures for forming a new business and their tax classifications: (1) a state law corporation classified as a C corporation; (2) a state corporation classified as an S corporation; (3) a limited liability company (“LLC”) classified as a C corporation or an S corporation; and (4) an LLC classified as a sole proprietorship or partnership.
State law corporation classified as a C corporation: Assuming that the new venture will be likely to be backed by a company from its inception, potential investors will generally expect that a Delaware corporation (or a corporation incorporated under another state law similar favorable) be formed and classified as a C corporation for tax purposes. Corporation C is generally subject to two levels of taxation, once at the corporation level and another at the shareholder level when the profits of the corporation are distributed. Therefore, in theory, the overall tax burden on a C corporation could be higher than it would be with a pass-through entity. Although this double taxation is generally considered the main argument against C corporation status, there are many other factors to consider. For example, the current federal corporate income tax rate of 21% is significantly lower than the top federal personal income tax rate of 37%. If the founders expect to reinvest as much of their company’s earnings as possible and limit dividends, the after-tax cash flow of a C corporation could be greater than the after-tax cash flow of a pass-through. In addition, shares of a C corporation are eligible for the special tax treatment of “qualified small business stock” or “QSBS” for certain investors if the requirements of Section 1202 of the Internal Revenue Code (“Code”) are met. . The attraction for investors to invest in QSBS is that capital gains from a future sale of shares in the company held for more than 5 years may be partially or fully exempt from tax. There are, however, many requirements that the company and its shareholders must meet in order to qualify for QSBS treatment. The basic requirements for QSBS status are that the company be engaged in an “active business” as defined in Section 1202 of the Code and that its gross assets cannot exceed $50 million before and immediately after issuance of shares. As with most areas of tax law, the requirements for QSBS status are quite complex. Yet, if founders and their companies meet the requirements, the benefits of QSBS status can be substantial.
State law corporation classified as an S corporation: Like the C corporation, an S corporation generally follows the same formalities, processes and procedures required to operate a public corporation. Unlike Corporation C, however, Corporation S provides pass-through taxation, meaning that the corporation itself would not be subject to income tax and the owners of the corporation would pay the taxes themselves. income taxes attributable to company profits. tax returns. (In practice, an S corporation would generally have to make tax distributions so that shareholders can pay their taxes on the income that is passed through.) This pass-through taxation can be attractive to founders who want to avoid double taxation. to which C corporations are subject, but this comes at the cost of restrictive ownership rules which may limit the ability to raise capital for the business in the future. For example, the basic requirements to qualify for and maintain S corporation status are:
- the company cannot have more than 100 shareholders;
- the company can only issue one class of shares; and
- shareholders must be US individuals (or certain trusts and estates).
The Company may not use investors who are entities, such as partnerships or corporations, all of which are common sources of capital raising. Additionally, if the corporation fails to comply with the S corporation rules, the corporation’s S corporation status would end, causing the corporation to be treated as a C corporation for tax purposes. S corporations are not eligible for QSBS treatment (discussed above). Therefore, founders who anticipate difficulty meeting the above requirements should consider other structuring options from the outset.
Form an LLC classified as a C corporation or an S corporation: An LLC generally offers the same limited liability protections as a corporation, but with greater ease of formation and fewer operational formalities. Additionally, an LLC can elect to be treated as a C corporation or an S corporation (if it qualifies as an S corporation) for income tax purposes. This allows a new business to benefit from the ease and flexibility of forming an LLC, while being able to choose to become a C corporation or an S corporation for income tax purposes. These aspects can make the LLC classified as either type of corporation for income tax purposes an attractive option. However, founders should also consider the company’s ability to raise capital and whether an LLC is an attractive investment vehicle for their target investors.
Form an LLC Classified as a Sole Proprietorship or Partnership: If the founders are not looking to raise capital immediately, the LLC classified as a sole proprietorship or partnership may be the most flexible option of all. For income tax purposes, an LLC is treated by default as a sole proprietorship if it has only one member or as a partnership if it has two or more members (in either case, as long as an election to be classified as a C corporation or an S corporation, as discussed above, is not made). The tax treatment of sole proprietorships and partnerships provides for pass-through taxation so that LLC members pay income taxes attributable to LLC income on their own tax returns. And, the founders can choose to incorporate the LLC or change its tax classification at a later date (via a “tick the box” election) depending on the preferences and expectations of potential investors. With subsequent incorporation or a checkbox choice, however, founders will need to consider whether this can be accomplished tax-free. Subsequent incorporation delays the start of the 5-year holding period and may make QSBS treatment unavailable if gross assets exceed $50 million at the time the LLC becomes a C corporation.
The above does not take into account international tax planning, insofar as this planning is consistent with the business plan.
other considerations: In addition to the tax considerations discussed above, founders must also consider corporate formalities and annual requirements imposed on business entities at the state level, all of which can vary from jurisdiction to jurisdiction.
By way of example (and by no means an exhaustive list), all corporations incorporated in Delaware are required to file an “annual return”, pay an annual “franchise tax”, which is in addition to any federal tax on income, to hold annual meetings, and to elect a board of directors.
- Annual Report: The information required in a Delaware annual report is the address of the company’s physical location, the name and address of an officer, and the names and addresses of all directors of the company. These details must be submitted annually, even if there are no changes from the previous year.
- Franchise tax: The annual franchise tax can be calculated according to one of the following methods: the “authorized share method” or the “assumed par value method”. Founders must use the method that results in the least tax.1
- Annual meeting: Delaware law requires every corporation to hold an annual meeting of shareholders at least once every 13 months. Generally, the date of the annual meeting is set out in the company’s bylaws and it must take place regardless of the number of shareholders.
- board of directors: Delaware law requires every corporation to elect a board of directors. In Delaware, the minimum requirement is one director, but other jurisdictions may require more.
On the other hand, LLCs generally enjoy greater flexibility in corporate governance. For example, most states, including Delaware, do not require LLCs to hold annual meetings of members or elect a board of directors (LLCs are generally “member-run” or “manager-run”. “, but the founders can set up a management structure of their choice in the LLC operating agreement), and at least in Delaware, the founders can contractually waive a number of obligations imposed by corporate law. Delaware corporations. For startups with limited resources, this flexibility can be invaluable. Also, Delaware LLCs do not file annual returns, but they are required to pay a flat annual franchise tax of $300 per year regardless of income or business activity. Flat fees can reassure founders that they know how much they have to pay each year.
Either way, founders should keep in mind that they can always convert an LLC to a corporation (or vice versa) when the time comes. Founders should discuss with legal counsel the pros and cons of each type of entity and the jurisdiction of formation before making their choice.
There are pros and cons to any business structure and tax classification. Choosing the best option depends on the founders’ plans for the business – there is no one-size-fits-all approach. Founders seeking to make an entity choice decision should consult with legal counsel to better understand the options discussed above and to consider potential alternatives.
1. More information on Delaware franchise taxes can be found here: https://corp.delaware.gov/frtaxcalc/
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.