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Startup Company Formation S is for Small: Plan Big and Long-Term

Industries: Technology

The Issue

When working with startups, one of the first questions from the entrepreneur is what type of legal entity is best for the new venture. One of the mistakes that is often made is thinking very short-term and not making sure the entity structure is consistent with the long-term growth and financing strategy. This is also the case when expanding internationally, but we will focus this discussion on the initial startup structure.

The Choices

There are five basic choices when setting up your venture. One is to not set up an entity and to treat it as sole proprietorship.  This, of course, will not work if you have co-founders and you will then effectively have a partnership even if you have not formed a legal entity. This choice is not advised and is at best a temporary solution until you can meet with your attorney and CPA and transfer the IP and other rights into a more permanent choice. The second choice if you do not have co-founders is to set up an LLC but elect with the Internal Revenue Service ("IRS") on your application for employer identification number (Form SS-4 Form and Instructions) to be a disregarded entity. This choice will give you the legal protection and marketing power of being an LLC, but the tax efficiency of reporting your income and expenses on your personal tax return on a Schedule C. The third choice is to formally set up a partnership (usually an LLC). The fourth choice is to set up a corporation and to elect an S Corporation election (Form and Instructions) to be treated as a small business corporation.  The fifth choice is to set up a C Corporation.

C Corporation Versus Flow Through

All of the choices except the C Corporation offer flow-through taxation, meaning the income and expenses are ultimately reported on the personal returns of the owners in most cases and no tax is paid at the entity level. The LLC choice allows anyone to become a partner and offers the most flexibility as to how all of the income and expense items are allocated to each partner. The S Corporation is a very rigid structure with significant restrictions including only allowing a single class of stock, a maximum number of shareholders and generally only U.S. citizens and certain trusts can be owners. It also requires the Company to pay salaries that are not unreasonably low and all distributions to owners must be pro-rata based upon ownership. If any of the S Corporation restrictions are violated, the company will automatically become a C Corporation. These flow through entities also allow the founders' to deduct the early research and development losses that flow-through to them but often not all of their early startup costs which may have to be amortized into the future. The C Corporation pays tax at the company level and does not pass through any profits or losses to the stockholders. Many sophisticated angels and venture capitalists will only invest in preferred stock with multiple preferences such as getting their money back first, etc. which automatically terminates the S Corporation status. At an exit, there is the possibility of double taxation on a C Corporation if the transaction is an asset sale since the company will have a taxable gain on the sale of the assets and then the investors will be taxed on the distribution of the net proceeds.

Pre-Tax Reform

Before the tax reform via the Tax Cuts and Jobs Act was signed on December 22, 2017, the highest C Corporation federal tax rate was 35% while the highest federal individual rate from pass-through income was 39.6%. If a C Corporation paid out all of the profits, the shareholders would also pay approximately 23% tax on dividends and net investment income.

Post-Tax Reform Section 199A Business Income Deduction

For 2018 post tax reform, the C Corporation tax rate is a flat 21% and the highest margin individual rate is 37%. Congress tried to also effectively reduce the tax rate paid by small businesses that drive the U.S. economy (i.e. on flow-through income) by establishing the Section 199A deduction. This deduction is up to 20% of qualified trade of business income or a percentage of qualified W-2 wages, which can dramatically reduce the tax liability.  However, most service businesses are excluded and the exact calculation is complex.

Section 1202 and 1045

For the founders and investors of qualifying C Corporation stock that meet a five-year holding period, there is a federal exclusion of income tax and AMT on the sale of their qualifying stock up to certain limits. In addition, shareholders that have an exit before the five-year hold have the opportunity to roll their proceeds over into other qualifying startups within 60 days and defer their capital gain (their tax basis rolls over). Note there are other requirements the C Corporation must meet in order to qualify.

Analysis and Conclusion

For traditional operating companies that do not plan to raise significant outside capital or have frequent changes in ownership an S Corporation may be a good fit, especially with the Section 199A deduction. Professional service or real estate firms that might have partners or assets leave, an LLC is often a great fit. However, for companies that plan to be high-growth SaaS companies that might raise outside capital, we highly recommend being a C Corporation from the beginning. This will show your future investors that you are focused on the long-term plan and also not eliminate the potential tax benefits of Section 1202 and the federal income tax exclusion including AMT up to limits after a five-year hold of the original issue C Corporation shares. Note if the company elects S Corporation to deduct their short-term losses, these founder shares will never be eligible for the favorable 1202 federal tax exclusion on the sale. Fast growing SaaS companies strategically plan to not "taint" their stock and put the 1202 treatment opportunity at risk, and the entrepreneur should not take this opportunity off the table to deduct a small amount on their personal returns upon formation. Electing S Corporation also sends a message to your potential investors that the founders have a small business mindset, not planning to build a large enterprise or think long-term.  If an entrepreneur is undecided on their long-term plans, we recommend an LLC which can generally be converted tax-free into another entity choice down the road if needed.

Reminders

We highly recommend that entrepreneurs work with an attorney with significant relevant startup experience and to establish a shareholders or partnership agreement that covers all important issues including management decisions, vesting, etc. Think of it as a prenuptial agreement. In addition, if the founders' equity is restricted and vests over time, an IRS Form 83(b) election should be filed otherwise the equity will be taxable at the fair value as it vests. Note this form has a hard 30-day deadline.

Brooks Malone

Technology Practice Leader

bmalone@hpg.com

+1.919.232.5905

@Brooks_Malone_