Which is better for an entrepreneur: an LLC or a C corp?

We have written from time to time on the question of which legal structure is best suited to private growth companies looking to raise outside growth capital.  Not surprisingly, there is no one right answer to the question, but recent tax legislation should compel entrepreneurs to give serious consideration to the C-corporation structure.

This article in last week’s Business Observer contains important news about the potential tax benefits of a C-corporation for entrepreneurs and their investors.

However… 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.

The author of the article (Pamela Schuneman,  C.P.A.) first argues that the prospects of federal tax reform may tip the scales towards choosing a C-corp:

Now, with tax reform on the horizon and a push to lower the corporate tax rate, current tax savings on C Corporation earnings could be substantial if the corporate rate drops to 15% and the top individual rate only drops to 33%. That’s an 18% difference — $18,000 more on $100,000 of income.

It’s a little more accurate to say the corporate rate drops “closer” to 15%, which compares favorably to an LLC structure where investors are taxed at their individual income tax rates on income that is “passed through” to investors.

Next she explains that a 1993-era tax provision governing a type of capital gains, originally scheduled to expire at the end of 2010, has been made permanent.  And this change, in our view, is a potential game changer.

The gain exclusion for Sec. 1202 was originally set [now made permanent – ed] at 50% for stock acquired [in private C corps – ed] on or after Aug. 11, 1993, increased to 75% for acquisitions after Feb. 17, 2009, and expanded to a full 100% exclusion for acquisitions after Sept. 27, 2010.

The 2010 law also removed of one of the main drawbacks of this tax provision – the alternative minimum tax preference.

In a nutshell, Sec. 1202 allows taxpayers (other than corporations) to exclude from federal income tax 100% of the gain from the sale of qualified small business stock (“QSBS”). The amount of gain excluded is limited to the greater of $10 million or 10 times the adjusted basis of the investment.

There are requirements to qualify for the tax break, which we outline below.  But first we’d like to share one more excerpt from the article to emphasize the importance of this legislation to founders and their investors:

For example, Tom and Jane decide to start a software development business. They purchase stock for $10,000 each and have a 50-50 ownership interest in the C Corporation. The stock is eligible for Sec. 1202 treatment if held for five years. In six years, they sell the stock of the company to Google for $10 million. They each have a $4,990,000 gain on the sale of the stock and their tax on the transaction is zero.

Of course we see this as a positive development for the high-growth companies responsible for all net job growth in our economy.  Reasonable people will disagree on what tax rates should be.  But can we at least agree that there are some forms of investment activity which promote economic growth, and that those forms ought to be encouraged, perhaps with favorable tax treatment?

RELATED STORY:  Warren Buffett and after tax returns

If a company’s stock is qualified small business stock (QSBS) then the Internal Revenue Code (§1202) provides a tax break on the equity investments.  To qualify as QSBS and for the 0%  federal tax rate on gains from the sale of QSBS, the following requirements must be met:

1.)  Original issue.  The taxpayer recognizing the gain must be an individual, partnership, S corporation or estate and must have acquired the stock at original issue from a US domestic C corporation.

2.)  Five-year holding period.  The taxpayer must have held the stock for more than five years prior to selling the stock.

3.)  After September 27, 2010. The taxpayer must have acquired the stock at original issue after September 27, 2010, in exchange for cash, property other than cash or stock, or services.

4.)  $50 million Gross Assets Test.  The aggregate gross assets of the corporation that issued the stock cannot have exceeded $50 million at the time of (including immediately before and after) the issuance of the stock to the investor.

5.)  Active Business Test.  During substantially all of the taxpayer’s holding period of the stock, at least 80% of the issuing corporation’s assets must be used by the corporation in the active conduct of one or more qualified trades or businesses.  (Certain types of businesses, including some pure service businesses like consulting firms or doctor practices, don’t qualify, but many businesses do.)

6.)  No significant redemptions.  The issuer of the stock must not have engaged in specific levels of buybacks (redemptions) of its own stock during specified periods (typically one year) before or after the date of issuance of the stock to the taxpayer.

The amount of gain eligible for this 0% rate is subject to a cap, however. Section 1202(b)(1) states that the aggregate amount of gain for any taxpayer regarding an investment in any single issuer that may qualify for these benefits is generally limited to the greater of  (a) $10 million, or (b) 10 times the taxpayer’s adjusted tax basis in the stock. For a taxpayer who invests cash in the QSBS, basis would generally be equal to the cash purchase price.

Like all issues tax-related, entrepreneurs need to consult with their tax counsel and accounting firm to determine if their businesses qualify for QSBS status.  If a business does qualify, an entrepreneur must decide whether these potentially significant tax savings outweigh other considerations.  In our view, Congress has now put its thumb on the scale firmly on the side of choosing the C-corporation structure.