I am sure the author of this article intended to help others make wise tax/entity formation decisions but many of the facts mentioned are just incorrect (tax rates and some general tax concepts). C-corps are fairly uncommon nowadays and for good reason You are almost always going to pay more tax in the C-corp and you will face built in gains issues when you realize this and decide to elect to be an S-corp.
The tone of the article seems to be slightly rushed and frustrated and leads me to wonder if the author just received unexpected news from his accountant.
One example:
Using 2013 tax rates and assuming that the taxpayer is single:
Individual Federal income tax on taxable income of $90,000 (ignoring personal deductions/exemptions/itemized deductions, etc..) that the example taxpayer in the article might have to pay if they were a 50% partner/member in an LLC:
Roughly $18,493 (less than 21%)
Corporate Federal income tax on $100,000 if you and your partner had a C-corp instead and took 40k salaries then left $100k in the company.
Roughly $22,250 (About 22%)
But then if you end up not spending that money because you made a boatload of cash the next year and want to take it out:
$3,337 (15% capital gains)
leading to a rough total of $25,587 (over 25.5%).
You might look at this example and say "hey that's just a few %" but as the income in question grows, so does the gap.
Edit: The real reason startups might end up as corporations is for the beneficial tax treatment investors can receive as holders of small business stock (1202, 1244).
C-corps are fairly uncommon nowadays and for good reason
This is a bit misleading for people looking to start your typical startup (using PG's definition of 'startup'). All those startups you read about raising money - want to know how many of them are C-corps? Just about 100%.
One thing that many people don't realize is that for many startups, those pass-through tax benefits of LLCs and S-corps are largely illusory, since they're not going to be profitable at that stage anyways.
Starting off as an LLC means you're going to introduce delay when you start raising money (unless you're really on top of things and convert in advance of fundraising), which introduces deal risk.
Yes, there is double taxation on income from C-corps, but most startup founders aren't in it for the salary / dividends, they're in it for the eventual acquisition / IPO (or these days, private market sales). Gains for QSB stock held more than 5 years are now tax-free under Section 1202.
There's a whole bunch of reasons why companies end up as corporations - not just the QSB stuff. Main street small businesses are often fine with LLCs or S-corps. Startups (as defined by PG) should really talk with an experienced startup attorney before going the route of an LLC or S-corp.
90% of my clients forming new businesses in the US last year chose the LLC form for legal purposes (only 1 client formed a new C-Corporation, which they did solely for legal requirements). They split 50/50 between pass-through and corporate treatment for tax purposes.
LLCs are relatively easy to convert to a C-Corporation, as are S-Corporations (which can automatically convert to C-Corporations). C-Corporations are generally very difficult and very expensive to convert to other forms.
So, C-Corporation status is great if you know that you will be getting VC funding. It's not so great if you only think you want VC funding, and it's a relative nightmare if you are trying to bootstrap.
You say starting off as an LLC means delay at fundraising. Unless you're advocating running entirely unincorporated, I think this is backwards: it is harder to convert your C corp to the form the investors will want than it is to convert an LLC. This was my understanding before last week, when YC's finance person confirmed it (at least as far as YC is concerned) on HN.
Thanks for pointing that out - I should have been more careful with my words. What I meant to say is that most startups will be better off starting as a C-corp, provided that they use market-standard paperwork (i.e. the forms that the major Silicon Valley law firms use, which many of them provide for free) and don't mess anything up (which is consistent with what Kirsty was saying). Of course, I suppose the "not messing anything up" part is harder done than said (which is why YC companies are lucky to have Kirsty) :)
I agree with the sentiment of your edit but would like to expand.
The key factor in an early stage company structural organization should be external risk reduction in relation to the founders and seed investors (they are already taking plenty of risk) while providing maximum return and low compliance costs. An LLC provides for this. If "institutional" investors come along then a change to a C-corp is trivial and low cost (when discussing securities sales it is almost non-existent if you are already selling LLC unit securities). The motivation being that the VC/Institutional investors are subject to a different tax structure if they buy units as opposed to shares (due to pass-through). So re-organizing as a result of an offer is completely reasonable in my opinion, just be upfront in discussions. This allows the LLC seed investors to take maximum profit and minimum risk during the pre-VC stage.
If you wish to contribute more to the business while organized as an LLC you can simply increase distribution percentage and have investors (yourself included) buy more Units (this eventuality must be prepared for in the original organization by providing enough units). And yes there is an element of "sales" to this with the current investors but if they bought in once and you paid them they should buy in again.
You will not stay LLC or S after taking a round of funding. But you won't keep your C corp either, because there are lots of details you will get wrong in forming it. It is very straightforward to convert a sane LLC to the C corp that investors want. It is not as straightforward to convert your C corp to theirs.
> Corporate Federal income tax on $100,000 if you and your partner had a C-corp instead and took 40k salaries then left $100k in the company.
> Roughly $22,250 (About 22%)
I think your shot-in-the-dark about getting "unexpected news from his accountant" is close to the mark, because the author didn't seem aware that the C-corp would have taxed the $100K at all. The comparison point was completely missing from the article.
The other missing point about C vs S/LLC: Later on, when the corp has grown like a weed and it's time to take money, there will be a double taxation under C that is very disadvantaged.
Honestly, this is a case where the HN commentary is better than the article it points to.
This guy is focusing on taxes when the better question to answer would be: "What corporate structure makes sense for you given your goals?"
There are a whole range of issues to consider of which taxes are but a single one. All sorts of things can complicate this which is why you need to really do your homework before you set up a structure.
For one thing, the author doesn't understand "retained earnings" in a C-corp. You can't just let that cash pile up indefinitely. There are "retained earnings" taxes that can hit you pretty hard if you're not doing things right. You also will get hit with the dreaded double-taxation issue once you do decide to take the cash out. And he's totally neglecting the issue of STATE corporate taxation which adds another layer of complexity to think about.
You choose your structure based on who is putting in money, how involved they will be in the business, what is at risk, and who gets what if the company is successful. That's it.
>C-corps are fairly uncommon nowadays and for good reason You are almost always going to pay more tax in the C-corp and you will face built in gains issues when you realize this and decide to elect to be an S-corp.
I think you are correct few start-ups and small businesses will ever incorporate and be taxed as a C-Corp. However, there are limitations to the S-Corps, such as a max of 100 shareholders and I think prohibitions foreign shareholders, so any public company is generally going to be C-Corp, the major exception I can think of are publicly traded banks who are N.A.s
C-corp taxes are subject to all sorts of rules. You can't do C-corp taxes on your own except in the most simple of circumstances. You definitely need a CPA (and a good one) if you're going this route.
A C-corp and an S-corp are equivalent in all but a few ways:
An S-corp is restricted in the total number of shareholders, and the classes of stock. It also can't have retained earnings. That's it.
S-corps aren't really popular any longer. Everyone who might have benefited from an S-corp is choosing to form LLCs instead. Less paperwork. Less formality. More flexibility. It's essentially a partnership with the limited liability of a corporation.
Because in a C-Corp, the earnings don't pass through to you personally. They belong to the corporation. So you pay tax on them at the corporate tax rate. Then when you personally want the money, you have to pay it to yourself as income. It gets taxed AGAIN. That's basically the only way for you to get the money. The idea is that with a C-Corp, if you want cash you earn in the corp to ever become your personal money, you have to take it out the year you earn it, otherwise those dollars will be taxed twice.
The tone of the article seems to be slightly rushed and frustrated and leads me to wonder if the author just received unexpected news from his accountant.
One example:
Using 2013 tax rates and assuming that the taxpayer is single:
Individual Federal income tax on taxable income of $90,000 (ignoring personal deductions/exemptions/itemized deductions, etc..) that the example taxpayer in the article might have to pay if they were a 50% partner/member in an LLC:
Roughly $18,493 (less than 21%)
Corporate Federal income tax on $100,000 if you and your partner had a C-corp instead and took 40k salaries then left $100k in the company.
Roughly $22,250 (About 22%)
But then if you end up not spending that money because you made a boatload of cash the next year and want to take it out:
$3,337 (15% capital gains)
leading to a rough total of $25,587 (over 25.5%).
You might look at this example and say "hey that's just a few %" but as the income in question grows, so does the gap.
Edit: The real reason startups might end up as corporations is for the beneficial tax treatment investors can receive as holders of small business stock (1202, 1244).