S-Corps, LLCs, and Tax Savings for Startups
We recently published a post on the Gust Launch blog explaining why Gust Launch is based on the incorporation of high-growth startups as Delaware C-Corporations. We were a little surprised by the response—a fair number of readers still advocated for LLCs, primarily due to the purported tax advantage of being a pass-through entity. Even though this difference is highly exaggerated for cash-strapped, high-growth startups, we realized that we hadn’t explained how the issue plays out, or how startups can take advantage of pass-through status without being LLCs. Read on to find out how!
LLCs, pass-through income, and the double-taxation myth
The number-one reason that many people are hesitant about incorporating a startup as a C-Corporation instead of as a Limited Liability Company (LLC) is because they’ve heard about the “tax advantages” of LLCs. A C-Corporation pays annual corporate taxes based on its taxable net income, and then if it distributes any money to its shareholders (known as “distributions”), the shareholders themselves are required to pay personal income taxes on the amount they receive.
In contrast, an LLC is effectively invisible (for tax purposes), and “passes through” any net income (without being taxed at the LLC level) to its owners, who then treat it as taxable personal income. Whether or not any money actually passes from the LLC to the individual, the individual owner must pay income tax on their share of the profits (or losses) generated by the LLC. That’s why every year at tax time, every LLC must send every one of its members (and the IRS) a Form K-1, showing their personal share of the company’s profit or loss.
Because of this, word of mouth among first-time founders is that a C-Corporation’s profits are “taxed twice,” compared to an LLC’s profits, which are only taxed once, and should therefore be avoided. Is this true? Yes. But…
It’s also almost entirely irrelevant for any high-growth startup—because almost none of them will have profits! (Remember that Amazon, today the fourth most valuable company in the world, didn’t show a profit for more than seven years.) Once a high-growth startup begins to generate revenue, it will almost certainly reinvest all of it in the business to fuel more growth, for at least the first several years. No profits to tax means no tax on profits, as well as no dividends paid to shareholders… so no personal tax on those nonexistent profits either. Therefore, for all the worry about double taxation in a high-growth startup, it’s almost always 2 x $0 = $0… or double taxation on nothing!
However, LLCs operating at a loss do offer their owners the ability to pass through some of that loss directly to their personal tax returns, thus reducing their net taxable income. This is genuinely attractive to many startup entrepreneurs, who are likely to be bootstrapping their businesses and forgoing a salary, and are therefore very grateful to reduce their tax burden.
Fortunately, there is a way to secure the same pass-through tax treatment for a C-Corporation, giving a founder the tax benefits of an LLC while still incorporating the "right" way for a high-growth business, and avoiding all the hidden headaches that come with the LLC route (including the difficulty of granting non-founder equity, document customization that results in mandatory legal bills, angry investors demanding their K-1s on time, and the eventual need to convert to a C-Corp). This magical solution is called the Sub-chapter S Election.
S-Corporations: LLC-style taxation on a C-Corporation chassis
The Internal Revenue Code (IRC) provides C-Corporations the option to elect pass-through status: they can simply file Form 2553, which changes the C-Corporation into a “Small Business Corporation,” popularly known as an S-Corporation.
The rules that determine which businesses can elect to be treated as S-Corporations are somewhat restrictive and a little confusing, but in practice end up working for most high-growth startups. To be eligible, a company can’t operate within certain industries, and must have fewer than 100 shareholders (although a married couple or an estate can count as a single shareholder), all of whom are individuals (or “certain trusts” and estates) rather than corporations or partnerships, and all of whom are residents of the United States. In addition, an S-Corporation can only have one class of stock.
The means an S-Corp is perfect for an initially founder-funded startup, and then when your first investors arrive, you simply drop your S-Corporation election and turn into an investor-friendly C-Corp with the ability to issue the Preferred stock that they will insist on purchasing. Also, professional investors often make investments through a corporation or partnership—both of which are deal-breakers for S-Corp status. When the time comes to convert tax status (because the company now has investors or no longer meets the requirements) it reverts back to C-Corporation status, requiring only minor legal, tax, and accounting support.
As neatly as the Sub-chapter S election solves the taxation issue, it turns out that there are actually millions of reasons why a high-growth founder may well want to start out directly as a C-Corp. That’s because...
C-Corps can eliminate taxes on up to ten million dollars of your personal gains!
Under certain circumstances, stock issued by C-Corporations counts as Qualified Small Business Stock (QSBS)—and after five years of ownership, the gains made on the value of this stock can be written off the personal taxes of the stockholder up to $10,000,000 or 10x the stockholder’s adjusted basis in the stock, whichever is greater. That’s right, greater! So the $10M in non-taxable gains is the minimum, provided you have $10M in gains in the first place (which of course you’re going to have, since you’re a high-growth startup, right?).
The kicker? S-Corp stock isn’t eligible for this benefit, and neither is any form of equity in an LLC. This is purely a perk for C-Corporations, and is why every true high-growth entrepreneur—one optimizing for an exit or an IPO, rather than a lifestyle business—chooses the C-Corp approach.
The requirements for equity to qualify for the QSBS exemption are relatively straightforward: stock issued by an active, domestic, C-Corporation that has less than $50,000,000 in assets right after issuing the stock. Virtually all newly-incorporated, high-growth, US C-Corp startups would meet these requirements.
Maybe save a little now, or maybe save a lot later
At the end of the day, this is the question that all startups considering LLC or S-Corp status have to answer: is the possibility of saving a small amount in taxes deducted from your personal income this year worth potentially paying taxes on up to ten million dollars in gains when you make it big?
Founders who choose Gust Launch are starting companies that they (and we!) hope will flourish, grow massively, and exit successfully. The ones that don’t—which statistically is most—will likely wind down without ever turning a profit. When the stakes are that high, and the trajectory is that ambitious, a small potential tax break today should never be more attractive than being investor-ready and serious (to say nothing of the legal savings of avoiding thousands of dollars for an LLC-to-C-Corporation conversion), and the potential tax break on a successful exit with QSBS is so massive that anyone not taking that into account should probably re-assess whether they are committed to a high-growth startup in the first place... or whether they would prefer to optimize for a successful, small, lifestyle business.
Wondering which legal entity is best for your startup?
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.