Posted by Early Growth
September 12, 2018 | 5-minute read (829 words)
By: Anjum Tunuli, Chief Tax Officer
Of all the tasks startup founders have to tackle, choosing a business structure might seem fairly mundane. But not only will your business entity have major implications on your exposure to personal financial risk and legal liability, it will also affect your financing prospects and that other certainty in life, taxes.
What do taxes have to do with business structure?
Minimizing your taxes might not be top of mind when profitability is years, possibly even an IPO away. But depending on your business entity type, your tax liability can be vastly different even with a similar level of earnings.
Let’s take a look at the most common business structures we see for startups.
1. Limited Liability Companies (LLCs). LLCs allow owners to limit their personal liability for obligations the business incurs. That means creditors generally cannot go after your personal assets to settle disputes involving your company. In general, your personal assets are also not exposed to legal claims. From a tax perspective, LLCs are considered pass-through entities. In other words, instead of the company filing returns and paying taxes, earnings (and losses) pass through the company and are reported on the owners’ personal tax filings. They then get taxed at regular income rates. Many startups initially set up as LLCs before converting to C-Corporations once they’re ready to attract outside investors.
Pass-through entities (LLCs, partnerships, sole proprietorships, S-Corps) got a big assist from last year’s Tax Cuts & Jobs Act (TCJA). The law created a new 20% deduction for “qualified business income.” While this sounds great, it comes with two big caveats. First, only certain types of businesses (for instance, professional services are excluded) and income qualify for the deduction. (If you don’t qualify, your tax rate could be as high as 37%, the top federal income tax bracket). Second, the new tax break is temporary; it will expire in 2025.
2. C-Corporations. Venture capitalists and other investors prefer these to LLCs or S-Corps because among other benefits, they impose fewer restrictions on who can invest and they allow for multiple classes of stock with different voting rights. The big disadvantage is double taxation.
This happens because corporations pay income tax on their net earnings and then individuals pay taxes on profits corporations distribute to them as dividends and/or on capital gains when they sell their shares. The good news is the TCJA slashed the corporate tax rate to 21% from as high as 35% (For more details on the tax changes read “The Top 7 Ways The New Tax Law Could Affect Your Startup.”) And corporations can delay the taxman by reinvesting earnings in the business. But double taxation is still a reality you will have to plan for. That said, if you are an investor in a C-Corp you can benefit from the Qualified Small Business Tax Exemption, which can save you from paying taxes on capital gains income should you ever exit the company via sale.
3. S-Corporations. S-Corps are similar to LLCs; they don’t pay corporate income taxes. Instead earnings and losses pass through to the individual owners tax forms. This is a much less common business structure for startups because among other things, the number of investors is capped and it doesn’t only allow for multiple classes of stock.
So how do you decide on a business structure?
Choosing a business entity isn’t a once and “forever hold your peace” deal. If you find your initial choice no longer fits, you can convert to a different one—but it will cost you in time and money. And you certainly don’t want to be doing it while you’re under the gun to raise funding or in deal negotiations. Obviously taxes won’t be the sole consideration, especially when you’re far from generating taxable earnings. Be thoughtful about where you are now versus where you eventually hope to be in terms of capital structure, financing needs, and overall business flexibility.
Professionals such as startup CFOs and lawyers with experience advising early-stage companies can help you analyze different business structures and walk you through the accounting, tax, and compliance implications of each to help you decide on a business entity that will meet your needs now and in the future.
Anjum Tunuli is Early Growth Financial Services’ (EGFS) Chief Tax Officer. An accomplished tax executive, with over fifteen years of experience, he works with successful small to mid-sized companies and their owners. Tunuli also has a very successful track record representing taxpayers before various taxing agencies and helping clients understand the full financial impact of tax planning on their operations.
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