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Startups Discover the Allure of the C Corporation
The individual income tax-rate cuts of the 1980s helped make LLCs the default business structure for startups – but the 2017 reduction in corporate tax rates, coupled with the capital gains tax rate increases in the 2010s, have changed the dynamic.
As last week’s Wall Street Journal explains in “Startups Discover the Allure of the C Corporation,” in some circumstances the ‘C’ structure creates potential tax benefits for entrepreneurs and their investors:
For years, Mr. Bisges started ventures using limited-liability companies, known for their flexibility and tax advantages. But when Mr. Bisges and his nephew, Aaron, started planning StillFire Brewing, their accountant suggested the C corporation.
Mr. Bisges is pinning this part of his business plan on Section 1202 of the Internal Revenue Code, an underused provision expanded under Mr. Obama, and one that is gaining new attention after the 2017 Tax Cuts and Jobs Act made it more attractive.
The strategy is particularly advantageous for business founders who expect to start small, keep earnings inside the company, make annual profits and then cash out. If a taxpayer holds C corporation stock for five years and follows the technical rules, capital-gains taxes on a subsequent sale get erased—on gains up to $10 million or 10 times the original investment, whichever is greater.
In a nutshell, the article argues that it may now be tax advantageous for entrepreneurs to realize their profits in the form of long-term capital gains instead of ordinary income because they can exclude from federal income tax 100% of the gain from the sale of qualified small business stock.
LLCs, S-Corps, and C-Corps each offer different advantages and restrictions, and choosing poorly can lead to expensive and difficult changes down the road. There are many complexities and issues to consider and no one right answer. Just as people shouldn’t decide to have children for the tax benefits, we advise founders to not view tax considerations in a vacuum when choosing the legal structure for their businesses. They need to think hard about the long term goals for the business and seek expert advice on the optimal legal structure.
You can, however, reduce the number of future headaches (and possibly legal bills) if you choose the structure that is most appropriate for both your current situation and your long-term objectives. Aside from avoiding personal exposure to business liabilities, the main considerations when choosing from among the three structures are tax consequences and corporate governance issues.
We ourselves have invested in both C’s and LLC’s, and have found the defined governance structure of a C-corp is almost always preferable. For a more expansive view of our thinking on the subject, we recommend you check out our 2010 white paper, To LLC or Not to LLC.