Amidst the chaos of starting a company, entity structure selection sometimes seems like an inconsequential but necessary box to check. While it isn’t the most exciting decision an entrepreneur will make, it’s definitely an important one as it can impact everything from raising capital to how much tax the owner pays when eventually selling their successful startup.
In part one of our two-part series on entity planning, we started comparing LLCs and C-corps from the perspective of startup tax losses, annual tax reporting and tax treatment for profitable companies. Below we dig into the effects of double taxation, the tax impact of selling ownership for these two entity types and key tax savings benefits for certain startup company stock.
Does double taxation apply?
LLC – Aside from states that have state-level LLC tax, an LLC is not subject to double taxation the federal level. This is the scenario in which the company pays tax on its profit, and then the owners pay tax on their cash distributions from the entity. For an LLC owner, as long as they have “tax basis” in their cash distributions, they do not pay additional tax on those distributions. Profitable LLCs only pay tax on the profit one time, which is done at the owner level.
C-corp – C-corporation profit, when paid out to the owners as dividends, is taxed two times. The first time is when the company pays tax on its profit for the year. Then, a second time when the owners are paid a dividend for the year because the owners are subject to tax on their dividend payments from the company. There are favorable tax rates for certain types of dividends, however, tax does apply still. As such, profitable C-corporations that pay out dividends every year are subject to double tax.
Are there tax benefits when selling ownership?
LLC – For LLC owners, aside from long-term capital gains tax treatment if ownership is held for over a year, there are no extra tax benefits at the point of sale for LLC ownership.
C-Corp – For C-corporation owners, there is a significant tax benefit for owning Qualified Small Business Stock, which is stock of a qualifying small business corporation. If the owner holds their stock for at least five years, they can sell the stock and avoid paying tax on the first $10 million in gain on the stock. This could even be higher depending on the amount they purchased their stock for, but they would at least get to exclude the first $10 million. At a 30% tax rate, which is not uncommon when federal capital gains tax, Net Investment Income Tax, and state tax apply, that would be a $3 million tax savings. This can be a huge tax benefit and incentive to invest in C-corporations that are Qualified Small Businesses, and a huge benefit to structuring as a C-corp or converting to C-corp prior to a significant funding round.
If the Qualified Small Business Stock is sold within five years, then the tax gain exclusion is lost. However, if those proceeds are used to purchase new Qualified Small Business Stock, then the gain on the sale of the first stock is deferred until the new stock is sold. While this does not give the owner the permanent gain exclusion, it does allow the owner to “serial invest” from one Qualified Small Business into the next.
Anders CPAs + Advisors works with startups and entrepreneurs on their financial needs so they can focus on what they do best. Contact an Anders advisor for assistance in determining your entity type.
Every day at Anders, we serve as a catalyst for those striving to achieve their highest potential, and carry this mentality on to our clients and community. Through a collaborative approach and a combination of tax, audit and advisory services, we help our clients achieve their goals.
As a tax partner and leader of the firm's startup practice, Dave Finklang particularly enjoys working with entrepreneurs and emerging companies by helping them raise capital, structure their businesses, implement accounting systems and minimize their tax burden. He has wide-ranging, specialized experience in tax planning, startup consulting and accounting services.
