Tax Reform: Why the Right Business Structure Is Vital for Tech Startups
The business entity you choose when starting a new company is more important than ever before in the wake of the new tax reform law.
Getting it wrong can mean higher taxes and could make it harder to raise capital because certain investors can’t or won’t invest in some business entities.
Getting it right can minimize risk to personal assets, create more legal protections, enhance opportunities to attract equity or other outside funding, and make it easier to administer and operate the company on a day-to-day basis.
Choosing the ideal business structure is especially important for high-growth startups in the software, IT security, payments processing, biotech and other technology sectors.
Each business structure has advantages and disadvantages as outlined here by the U.S. Small Business Administration.
Some of the most common business structures are:
- C corporations, which are separate legal entities that pay taxes and can be held legally liable for their actions while avoiding personal liability for the owners or shareholders.
- S corporations, which also offer legal protection for its’ owners and allow income or losses to pass through to the personal tax returns of the owner(s).
- Limited Liability Companies, which have become more popular because they shield the owner from personal liability and the business itself doesn’t pay taxes because any profits or losses are passed through to the personal tax returns of the owner(s). However, some investors such as venture funds tend to avoid LLCs.
- Partnerships, which involve two or more people who agree to share in the profits or losses that are passed through to the personal tax returns of the owners, and each partner remains personally liable for the financial obligations of the business.
- Sole Proprietorships, which are one of the most common and easiest entities to form because the owner has complete managerial control yet also has personal liability for the business’s financial obligations. One way to solve the liability concern is to form a Single Member LLC which can operate as a Sole Proprietorship for tax purposes.
Entrepreneurs who are starting a new business after the passage of the Tax Cuts and Jobs Act of 2017 have some additional implications such as tax rates to consider, and a CPA or legal advisor can help you choose the one that is right for your particular business.
Here are some things that shrewd business owners must consider when choosing a business entity that will be most advantageous.
Many entrepreneurs who are starting new companies that plan on seeking outside capital to fund early-stage growth choose to use the C corporation structure.
Venture capital, private equity, investment banks and other investors often prefer C corporations, as do institutional investors such as mutual funds or pension funds. Many startups that hope to someday do an initial public offering (IPO) also prefer to start life as a C corporation, or convert to a C corporation before selling shares to the public.
A massive new advantage for choosing the C corporation structure is a new lower corporate tax rate of 21 percent, down from 35 percent previously, that was a hallmark of the tax reform law.
The tax reform law dangled another carrot for C corporations with exports in the form of a new Foreign Derived Intangible Income (FDII) provision that lets them pay an effective tax rate of just 13.125 percent on a certain portion of income derived from abroad on the sale of goods, services, property and royalties from licenses, patents and trademarks. Check out our other blog post to learn more about FDII.
C Corporations and other business entities can also take advantage of research and development tax credits, which can effectively reduce tax rates.
To be sure, one disadvantage of C corporations is that they are subject to double taxation. The entity itself is taxed, as are capital gains or losses for investors and other shareholders.
Famed New York venture capitalist Fred Wilson points out that, although many startups begin life as LLCs they are likely to become C corporations by the time they need to start raising outside capital.
“When your business is small and ‘closely held,’ an LLC works well,” Wilson writes. “When it gets bigger and the ownership gets more complicated, you’ll want to move to a C corporation.”
When entrepreneurs are pretty confident that they will someday need venture funding of capital from other sources, it may be best to simply start as a C corporation from the very beginning to save on administrative and legal costs and hassles of converting later. It’s also worth noting that many companies register as C corporations in the state of Delaware, even if they are not physically based there, because of favorable tax and regulatory laws.
An S corporation is an attractive hybrid that offers both legal protection and the benefits of a pass-through entity that’s not subject to double taxation.
As a pass-through entity, the S corporation’s owners pay taxes once on the flow-through income derived from the business that they report on their personal tax returns.
Thanks to the new tax reform law, the owners of S corporations can now take advantage of a new Section 199A provision that allows them to deduct as much as 20 percent of qualified business income when they file their personal tax returns.
S corporations also get a break in payroll taxes, wherein the business and its employees each pay a 7.65 percent tax on the first $132,900 in income for Social Security and Medicare, and a 1.45 percent tax for income above that amount. Distributions of profit or dividends to shareholders aren’t subject to the employment tax, although they are taxed on the recipient’s personal income tax filing.
Some downsides to S corporations is that they can only have one class of stock and they are limited to 100 shareholders, all of whom must be U.S. citizens. Those restrictions make this entity less appealing for fast-growing tech companies that are planning to raise outside capital.
If the founders of a company plan to “bootstrap” or self-fund the company or raise small amounts of so-called “seed” investment from friends and family, a Limited Liability Company (LLC) can be the way to go.
LLCs protect business owners from personal liability should the business fail or have financial difficulties, and they allow the flexibility to create separate classes of equity known as “membership interests” that are common in startup equity fundraising.
Like S corporations, the LLC’s owners only pay taxes once on the flow-through income, which they report on their personal tax returns. For early-stage startups that are losing money, the flow-through loss can be beneficial in lowering the owner’s taxes.
The owners of LLCs can also use the Section 199A pass-through deduction for up to 20 percent of qualified business income, although losses must also be carried forward.
Should a liquidity event occur, such as the sale of the business, an LLC’s investors or owners will face just one level of taxation at a rate of 37 percent that is somewhat mitigated by the 199A deduction.
As mentioned earlier, many high-growth tech startups that begin as an LLC find that they must later convert to a C corporation in order to raise capital or go public, and that incurs accounting, legal and administrative costs.
Partnerships & Sole Proprietorships
These are also pass-through entities, and both have so many restrictions for potential future investors that neither is common for fast-growing tech companies.
Partnerships tend to be a better fit for accounting firms, law firms and health care practice groups where each partner might have different allocations for profits and losses and the partnership may add or remove people frequently in the course of business. A sole proprietorship is an unincorporated business owned by a single person and tends to be a better fit for people who intend to always work independently, such as a bookkeeper, housecleaner or hairstylist who rents a chair at a salon.
That said, partnerships or sole proprietorships may be the right choice in certain circumstances. If the owners of a tech company decided to buy an office building that became available for purchase, they may decide to create a separate real estate partnership to buy the building.
The business structure a startup chooses can have a range of implications from taxes to corporate governance and the ability to attract investors.
Founders of high-growth companies that intend to raise venture capital or other sources of funding or might do an IPO someday often choose a C corporation structure. A new lower corporate tax rate of 21 percent makes C corporations especially attractive.
The most common pass-through entities are S corporations, which have ownership restrictions that can dissuade outside investors, and Limited Liability Companies, which are easy to create but can necessitate conversion to a C corporation down the road. The owners of these and other pass-through entities can now deduct up to 20 percent of qualified business income from their personal taxes under Section 199A of the new tax reform law.
A CPA can help you decide which startup business entity is the best fit for your new business, and when appropriate, can help convert your business to another entity that is more advantageous.