Any hesitation in the startup and early-stage capital markets during the pandemic seems to be quickly disappearing as we continue to see more capital raises in 2021. With this positive momentum, it’s a good time to pause for a moment to discuss an often-overlooked part of the capital raising process: entity structuring. Taking the time to evaluate the best entity structure for the company will best position the founders and incoming investors.
Below is part one in our two-part series of key questions to consider when comparing the two most favorable entity structures for growth stage companies in search of significant outside capital: LLCs and C corporations. Keep in mind that any planning for a funding round should include your legal and startup tax advisors.
Who benefits from startup tax losses?
- LLC: The individual owners (i.e., investors) reap the benefits of the tax losses from the company, as LLCs are referred to as “flow-through” entities. Simple in concept, but much more complicated in execution, LLCs split their losses for the year based on some percentage, either a profit/loss percentage or a special allocation percentage, between the owners. The owners then report their share of the LLC losses on their individual tax return for the year. Depending on the tax basis rules and the tax passive loss rules, the owners may be able to deduct their share of the LLC’s losses against their other income sources for the year, which, then reduces their overall tax for the year. While the tax deductions are not a dollar-for-dollar offset to the owner’s tax, they do serve some immediate economic benefit to the owner versus waiting purely for an earn-out event or dividend in the future.
- C corp: The company itself benefits from the tax losses generated during the year. This is because C corporations are their own taxable entity in the eyes of the IRS, so the company is subject to tax at the entity level. If the company generates a loss, then the company does not pay any tax that year. It’s important to note that this applies to federal tax and many states. However, some states do have minimum tax amounts that are assessed regardless of profitability. Any losses not used in a year generate a net operating loss (NOL).
Are owners subject to annual tax reporting with an ownership interest in the entity?
- LLC: Due to the flow-through nature of an LLC, the entity’s owners are subject to yearly tax reporting. This reporting is done by way of a “Schedule K1” from the LLC to the owner. The K1 is how the company reports each owner’s share of profit or loss for the year. Since the K1 is needed to file the owner’s individual tax return for the year, the owner will have to wait for the company’s tax return to be completed for the year, as the K1s are prepared with the company’s tax return for the year. In other words, the K1s are not stand-alone forms that can be prepared ahead of the company tax return like an employee’s W2 form can.
- C corp: Since C corporations are their own taxable entities, the owners are not subject to tax on the C corporation’s taxable income for the year, just as the owners do not benefit from the C corporation’s losses for the year. There is no additional tax reporting from the C corporation to the owner for the year, which means owners of C corporations do not have to wait for the C corporation tax return to be filed to file their individual tax return for the year.
Who pays tax once the company becomes profitable?
- LLC: Just as the owners benefit from the tax losses from the LLC, they are also responsible for paying the tax on the company’s taxable income for the year. Most owners are shocked to hear this, as why would they have to pay the tax on the company profit? While on the surface this seems counterintuitive, it works to tax the company profit only one time at the owner level. Since the owners are paying tax on the company income, most LLCs will make cash distributions to the owners to pay the tax. These are called tax distributions and effectively make it so the company is using its cash to pay tax. It just requires the tax to be reported by the owner, who is then given company cash to pay tax.
- C corp: Just as the company benefits from its tax losses, it also pays the tax in profitable years. As such, there is not the need to pay tax distributions to the owners because their tax returns are not impacted by company tax profit.
As with any company structural decision, there is not one of the above factors that should be the sole decision point for deciding between an LLC and C corporation for your startup company. A planning discussion around all of these factors, as well as the legal implications of each entity, should be engaged in prior to determining the legal entity type for your startup before starting your funding round. Stay tuned for our next installment that considers double taxation, the tax impact of selling ownership for these two entity types and key tax savings benefits for certain startup company stock.
Anders CPAs + Advisors works with startups and entrepreneurs on their financial needs so they can focus on what they do best. Learn more about the Anders Startup Group and contact an Anders advisor for assistance in determining your entity type.
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