How the new US tax laws affect startups
In December of last year, Congress passed the largest tax bill since 1986. The wide-ranging changes affect everything from personal income taxes to pass-through entities and corporate taxes. Since taxes are a critical consideration for every business venture, it’s important for founders to understand how these changes may impact high growth startups.
Before we begin, let’s note that the dust has barely settled on these new laws. The Treasury and IRS have yet to publish any materials to provide guidance on how to interpret them. Because this leaves a lot of room for adjustment to the real-world effects of the changes, it will be important in the future to continually update your understanding.
Big Changes in Corporate Taxation
Down goes the corporate tax rate:
Beginning this year, the corporate tax rate (which applies to C-Corporations) is dropping from 35% to 21%. This is a change that has been heavily discussed amongst tax scholars for many years. Some claim that this rate puts the country’s corporate tax rates more in line with other developed countries. Sidestepping a discussion of the political and economic merits of this change, this clearly means that income-producing corporations will be retaining more profits. For startups, which generally do not generate profits in the early years of the business, this rate change will have little effect.
International Taxation has been flipped on its head
The US is moving from a global taxation regime (taxing profits on US companies regardless of where in the world they are earned) to what is called a territorial tax system. A territorial international tax only taxes corporate income that is earned within a country’s borders. This means that a US company that earns income in, for example, the United Kingdom now only has to pay taxes in the UK without having an additional US corporate tax being levied on the UK-sourced income. Territorial tax systems are the norm for many other developed economies. Some believe that this change could lead to higher investment in the United States.
Certain assets can now be immediately depreciated rather than capitalized.
For many companies, purchasing equipment is a vital and expensive part of the overall operations. Previously, most of these large outlays had to be capitalized (spreading the expense of a long-lived asset out over time). This meant that the expense deductions that a company would take on their corporate tax filings would have to be depreciated over the asset’s “useful life.” The useful life was determined by the asset class, and there are corresponding depreciation tables to inform the company on how they can take that deduction over time.
Now, some of these assets can be fully deducted in the year they are purchased. The company will get to write off the full value of the expense in the year it was purchased. This could lead to an increase in capital spending by companies and is one of the less-discussed major changes in this new tax regime.
The AMT threshold is going up
The Alternative Minimum Tax (AMT) was completely removed from corporate taxation and the threshold amount that taxpayers must cross before being taxed through the AMT has been drastically raised for individuals. In short, the AMT is a tax system that aims to prevent excessive accumulation of deductions that a high income earner could take with the intention of paying no tax at all. This is a system that sits alongside income taxation and is a fairly complicated calculation.
Previously, the AMT phaseout threshold was $120,700 for individuals and $160,900 for married filers. Now, the threshold is $500,000 for individuals and $1,000,000 for married filers. For startups and other high growth companies, this means the bargain element from ISO stock options that are a part of the AMT will now subject fewer employees to tax liability. There were previously many higher-income employees at startups with substantial unrealized gains on their ISO stock. Now, the new tax laws give those individuals a cause for relief.
Introducing § 83(i)
Another change that has not necessarily grabbed headlines but will still touch some high-growth ventures is the inclusion of § 83(i). This new subsection allows certain “qualified employees” in “eligible corporations” to defer the taxation of certain stock options and settlement of Restricted Stock Units. If the employee’s stock option or RSU satisfies these requirements, it could allow the employee to avoid paying any taxes on the exercise of that stock option for as long as 5 years.
There are several limiting factors and requirements for both the company and the employee to be able to have their options or RSU qualify for this deferment. It is also important to note that it is not entirely clear how many startup employees will take advantage of this new election if they qualify. There are still many questions that remain unanswered and hopefully, over the coming months, tax experts and regulators will provide some clarity.
What does seem readily apparent, though, is that 83(i) gives some tax relief to those employees (subject to the limitations) who have NSO options and are thinking about exercising. Unlike ISO options that are not taxed at exercise, NSO options are taxed on the difference between the option’s strike price and the fair market value of the underlying stock at exercise as income attributable to the employee. 83(i) shields these employees from having to swallow any of the income tax from exercising NSOs, at least for a time.
It also got a lot better to be a pass-through entity
Some holders of pass-through entities (the S corps and LLCs of the world) can now take a 20% deduction on any income attributable to the entity. In other words, many businesses other than C-Corporations will also pay lower taxes. Starting this year, an individual with “qualified business income” from a pass-through entity will be allowed to take a 20% deduction from that income. The deduction is limited and phased out based on W-2 above a certain level. There are also special provisions for capital-intensive businesses. The deduction is not available to “specified services or businesses,” which means businesses operating within the health, law, consulting, athletics, financial services, or brokerage services industries, as well as any business where the principal asset is the reputation of the employee(s). It's also not available to taxpayers with income above $157,500 ($315,000 for joint filers).
Obviously, the tax strategies businesses will develop to make use of the new deduction have yet to be seen. In addition, there will likely be new business entity structuring practices that will maximize its utility. Over the next few months, we will probably start to hear about all the creative ways that tax practitioners find to best utilize this deduction for pass through entity owners.
With all of these changes, should high-growth startups still be corporations?
After evaluating the new tax changes, it is still highly likely that most high-growth, scalable, venture-capital-seeking businesses will continue to choose C-Corporations as their business entity, since the underlying reasons most high-growth startups are C-Corps have not changed.
- The tax rate has been lowered for C corps and startups generally don’t pay dividends. Most startups put every dollar they make into the business to grow and scale their business. The corporation will now pay less in taxes on any income they make, and startups that are C corps already don’t pay dividends, so there are still no double taxation concerns to worry about.
- The qualified small business stock (QSBS) under § 1202 still only applies to C corps. This exemption says that stock owners in qualified C-Corporations can exclude $10 million or 10x aggregate adjusted basis (higher of the two) at the successful exit of the business.
- Venture capitalists have not done anything to suggest that they will no longer prefer to invest only in Delaware C-Corps. VCs still want to limit the legal and regulatory complexity of their portfolios. Because of this, it is unlikely that their preference to invest only in Delaware C-Corps will change with the new tax laws.
This new tax regime has brought many changes, with the consequences yet to be fully understood. For now, though, it looks like startups should be pleased with the updates. Some of the tax-disadvantageous reasons to be a C-Corporation have been reduced and employees with stock options have some new reasons to celebrate. As these changes and their effects for startups are better understood, we will be sure to keep you updated.
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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.