What are the primary considera.ons for startups considering a corporate en.ty status?
Corpora4ons provide numerous advantages to a startup business. A benefit is the ability to customize the management structure to meet the needs of the entrepreneur(s) and the outside investors. The corpora4on offers the greatest degree of personal liability protec4on for owners in their roles as shareholder, director, or officer. It also allows flexibility in providing employees with equity incen4ves, such as ves4ng plans and op4on plans. There is also a litany of tax- associated benefits both for C and S corpora4ons.
What about the C corpora.on maintenance requirements?
The corporate en4ty form provides a comprehensive business structure, limited liability for employees, and the ability to sell and distribute shares to equity investors. There are two primary concerns when selec4ng C corpora4on status: en4ty governance requirements and the double taxa4on of business profits. In general, the corporate form requires far more formal maintenance procedures than other en4ty forms. These requirements are discussed in greater detail in Chapter 9.
What are the benefits and detriments of the double tax structure?
The double taxa4on structure will oaen lead to higher tax liability for owners of the corpora4on than in a pass-through taxa4on en4ty. There are scenarios, however, where the double taxa4on of corporate profits will yield a lower total tax burden on owners. This is possible because of the ever-changing taxa4on rates and the responsibility of individuals to pay self-employment taxes on certain pass-through income.
• Note: The individual and corporate taxes rate changes from year to year. In any given year a combina4on of the corporate tax rate and the individual dividend rate may be
lower than the taxpayer’s individual income tax rate. This is par4cularly true when you include responsibility for payroll or self-employment taxes, which are not included in dividend payments.
• Example: Derek is the sole owner of a C corpora4on. The corpora4on earns profits of $10,000 in a year. The corpora4on will pay taxes on the income at its corporate tax rate. We will use 25% for purposes of this example. This leave $7,500 in profit. Now, when this $7,500 is distributed to Derek, he will pay taxes on the dividend at the applicable dividend rate. We will use 20% for purposes of this example. Aaer taxes, Derek will receive $6,000 of the aaer-tax profits of the corpora4on. If the business were a pass- through en4ty, such as an LLC, Eric may be subject to self-employment taxes on the profits, as well as personal income taxes. If his personal income tax rate is 36%, and his total self-employment tax liability is 15.8%, then he would receive $5,820 in aaer-tax profits of the LLC.
One advantage to the double taxa4on regime is the ability to retain profits (and in some cases losses) at the corporate level. As is the case in startups, if the investors wish to reinvest profits, the C corpora4on avoids the issue of “phantom income”. As previously discussed, phantom income arise when a business owner is taxed on her share of business profits when there is no distribu4on. The disadvantage of this scenario is that business losses are not passed through to shareholders; rather, the corpora4on retains these loses. These losses are generally available to offset income from the past 2 years and for the next 20 years. In the event of a merger or sale of the corpora4on, these losses can be valuable to the acquiring en4ty.
- Example: Tom owns a C corpora4on. It makes a profit at the end of the year of $30,000. The corpora4on will have to pay income taxes on that $30,000 at the applicable corporate tax rate. If the business does not distribute any of the profits to Tom, then he does not pay taxes on those funds. If the business were organized as a LLC or S corpora4on, then Tom would have to pay taxes on the profits aFributable to him as owner. In other words, the C corpora4on en4ty form avoids the “phantom income” situa4on.
- Note: Accumulated losses are not lost in a startup that seeks to benefit investors and owners at the 4me of business exit. Any losses retained by the corpora4on at the 4me of an exit event (e.g., sale of the business) can be used to offset any capital gains taxes incurred by the owners/investors at the 4me of sale. Congress has also enacted special rules to benefit small business owners opera4ng in the corporate form.
- What other tax benefits exist for the C corpora.on?
A detailed descrip4on of the tax benefits associated with any business en4ty are beyond the scope of this text; however, it is important that you have a general understanding of the primary tax benefits available for startup ventures. Below is a list and short descrip4on of many of the tax-associated, C corpora4on benefits for further research.
• Shareholder and Employee Benefits – The corpora4on can provide to shareholders and employees certain health, welfare and re4rement benefits that are tax deduc4ble to the corpora4on.
- Fiscal Year Elec.on – The corpora4on has greater flexibility in designa4ng a fiscal year other than the calendar year.
- Long-Term Capital Gain Rates – Gains on the sale of stock of a C corpora4on held by a shareholder for more than one year are taxed at a 15% tax rate. This is oaen far lower than the tax rate for individual income.
- Ordinary Loss Treatment – IRC Sec4on 1244 allows the shareholder of a qualifying C corpora4on to treat any losses on the sale of the corpora4on’s stock as an ordinary loss up to $50K for individuals or $100K for married couples per year. This means that the losses can offset ordinary income. Generally, such losses are treated as capital losses and can only be used to offset capital gains. To qualify, the C corpora4on cannot have a market capitaliza4on (contribu4ons and retained earnings) greater than $1 million, and the shareholder must be the original purchaser of the loss-producing shares sold. This means that shares awarded for services rendered to the corpora4on are not eligible for the ordinary loss treatment.
- Qualified Small Business Stock Benefits
- ⁃ IRC Sec4on 1045 allows individual shareholders to defer the recogni4on of any gain on the sale of qualified small business stock (QSBS). The requirements to qualify as QSBS are extensive. The corpora4on must have less than $50M in gross assets at the 4me of issuance; the issuance must take place aaer Aug 10, 1993; the shares must be acquired by the original issuee; and the shares must held by a non-corporate taxpayer. For a transac4on to qualify, the shareholder must have held the stock for longer than six months. Further, the proceeds from sale must be reinvested in another qualified small business within 60 days of the date of sale. Deferring the recogni4on of any gain on sale can be very aFrac4ve for startup owners.
- ⁃ IRC Sec4on 1202 allows shareholders to exclude from income up to 50% of the gain on the sale of the QSBS up to $10 million or ten 4mes the shareholder’s basis in the stock, whichever is greater. There are, however, significant limits on this provision. This provision applies to QSBS issued directly to C corpora4on shareholders aaer Aug. 10, 1993. The exclusion is not available to shareholders who are not the original issuee and the C corpora4on cannot have more than $50 million in assets at the 4me the stock is issued. The downside to this provision is that the 50% of the gain that is recognized is taxable at a flat 28%, which is well higher than the current 15% long-term capital gain rate.
What other tax detriments exist for the C corpora.on?
The primary tax detriment for C corpora4ons, discussed at length throughout this text, is the double taxa4on structure. Much 4me is spent in corporate tax planning to avoid the nega4ve
consequences that exist in this structure. Below are a few of the major tax detriments associated with the C corpora4on:
- Corporate Losses – The shareholder of a corpora4on cannot use or otherwise take advantage of corporate losses. In an S corpora4on, the en4ty losses flow through to the taxpayer. This is not the case in the C corpora4on. Losses are trapped at the en4ty level and can generally be used to offset profit in the previous 2 years or in the following 20 years.
- Fixed Corporate Basis – Startups organized as C corpora4ons oaen distribute stock to shareholders in exchange for value to the corpora4on. The value of services, cash, guarantees of debt, or property provided to the corpora4on in exchange for the stock is the shareholder’s basis in that stock. The shareholder’s basis in that stock remains fixed and does not vary with the performance of the corpora4on, as is the case with other en44es. The ability to adjust one’s basis can be a significant advantage for the shareholder, but this ac4on is not available in the C corpora4on without addi4onal contribu4on of capital.
- Capital Gain Rates – Capital gains on the sale of property held by a C corpora4on are taxed at the corpora4on’s ordinary income tax rate. In a flow-through en4ty, however, owners enjoy a lower personal capital gain rate on the sale of property by the en4ty.
- Redemp.on of Stock for Cash – If a C corpora4on redeems (repurchases) the stock of a shareholder, then the en4re purchase price is treated as a dividend to the shareholder to the extent of the corpora4ons earnings and profits. Currently, dividend and capital gain rates are equal. The issue, however, is that the shareholder’s basis is not recovered prior to trea4ng the distribu4on as a dividend. The shareholder may be forced to claim a capital loss on the transfer of the stock back to the corpora4on. There is, however, an exemp4on to this rule under IRC Sec4on 302(b). This provision allows the shareholder to treat the redemp4on as a sale of the shares to the corpora4on if certain requirements are met. As such, upon redemp4on, the shareholder recovers her basis in the shares before incurring a tax liability for the gains or losses incurred. When considering redemp4on of C corpora4on stock, consult a professional to plan for a redemp4on scenario with the lowest possible tax repercussions.
- Redemp.on of Stock for Property – The above scenario demonstrates a nega4ve tax consequence when a corpora4on redeems the equity of a shareholder for cash. Another issue arises when the corpora4on redeems those shares for property in the corpora4on. If the property has a built-in gain then the distribu4on will cause a gain tax to the corpora4on and a dividend to the shareholder for the fair market value of the property. As is the case above, the corpora4on can avoid this tax consequence if an IRC Sec4on 302(b) excep4on applies.
- Excess Accumulated Earnings – IRC Sec4on 531 allows for a tax penalty on C corpora4ons that retain excessive earnings, rather than distribu4ng those earnings to shareholders. A corpora4on must show a reasonable business need for retaining such earnings to avoid a
20% corporate tax penalty on those earnings. This situa4on is generally not a concern for startups, as most startups readily employ their earnings in growing the business and have a reasonable business need for retaining earnings.
• Alterna.ve Minimum Tax (AMT) – Corpora4ons are subject to the AMT. This is a complicated calcula4on that makes certain that corpora4on pay income tax on a minimum percentage of aFributed income in a given year. It seeks to avoid the effects of excessive deduc4ons, credits, and other tax deferral arrangements on the corpora4on’s income tax liability in a given year. There are numerous exemp4ons for new corpora4on with less than $5M in gross receipts within the first 5 years of opera4ons and less than $7.5M in gross receipts in any 3 years of opera4ons. The AMT is normally not a threat for startup ventures that oaen incur extensive losses during the development stages.
How does the C corpora.on equity structure benefit the startup?
Lastly, and probably the greatest advantage for entrepreneurs, the C corpora4on allows for the authoriza4on and distribu4on of mul4ple classes of stock. While founders of a corpora4on receive common stock, equity investors generally require preferred stock interests. Preferred equity provides the investors with various levels of protec4on from loss, such as a dividend preference, liquida4on preference, par4cipa4on rights, redemp4on rights, etc.
• Note: The preferences generally regard the right to recover one’s invested capital before any other equity owners receive any proceeds of an exit (known as a “liquida4on preference”). The details of preferred stock and terms of investment are complicated subjects that exceed the scope of this text.