Corporations and LLCs offer what’s called “limited liability” protection to their owners, meaning that the owners can lose what they literally invested, but the rest of their assets are insulated from the debts and obligations of the entity. Yay!
Now, tax. Partnerships offer “pass-through” taxation, which means that the company itself does not pay tax on gains (or take the losses) – it “passes them through” to the owners. So gains are taxed only once (at the owner level), and losses can (often) be taken by the owners personally to offset gains from other income, which is a nice benefit.
“C” corporations don’t get this benefit. Losses remain in the entity, and gains are taxed at the entity level – and then if subsequent distributions are made to the owners, these are (generally) taxed as well. This is so-called “double taxation.”
LLCs often elect to be taxed as partnerships. When they do, you’ll sometimes see them referred to as LLC-Ps.
“S” corporations (another tax designation you may have heard of) are a lot like partnerships, but there are several downsides, including limitations on the number of owners, (cannot exceed 100), the type of owners (generally just humans) and the types of shares they can sell (only one type allowed; more on why this matters in the chapters that follow). They just don’t work well for tech and biotech startups.
So if you are a tech or biotech startup, it seems obvious, no? An LLC-P! Why organize as a “C” corporation and suffer double taxation? Seems crazy! I mean, we all want to do our part as good citizens, but still…
But if you are reading this article, you’ve likely heard that, in this space, the “C” corporation – in particular, the Delaware “C” corporation – is the preferred form. But why?
Well, for one thing, “C” corporations can take advantage of Section 1202 of the Internal Revenue Code (IRC). I try to limit tax talk where I can in this article, but sometimes it’s important, and this is one of those places. Section 1202 addresses something called “Qualified Small Business Stock,” or QSBS. It’s a bit technical, but the bottom line is that for founders, the stock they are issued almost always qualifies, and if they hold that stock for at least 5 years, they will (generally) pay no tax on the gain. Wow!
It’s a bit technical, but the bottom line is that for founders, the stock they are issued almost always qualifies, and if they hold that stock for at least 5 years, they will (generally) pay no tax on the gain.
Exactly. Wow! And Section 1202 does not apply to LLCs.
Further lessening the blow, buyers of startups (those big whales who will buy your company in a liquidity event or exit transaction) are accustomed to buying “C” corporations. There are provisions of the IRC that they frequently will take advantage of which lessen or even sometimes eliminate the pain of double taxation. These provisions are not applicable to LLCs.
Finally, traditional venture capital investors have a strong aversion to pass-through entities. Their tax-exempt investors don’t want something called “unrelated business taxable income” (UBTI), and their foreign investors don’t want to get swept into the US tax regime. Both are a greater risk with pass-through entities than with “C” corporations.
(Plus, to be frank, the day-to-day administration of LLC-Ps is a hassle. “C” corporations are just easier).
Ok, so that explains “C” corporations.
As a general matter, corporate law in the US resides at the state level. There really isn’t “federal” corporate law.
For a variety of reasons – history, traditional, custom, practice, highly-evolved statutes, responsive agencies, sophisticated courts, and so on – Delaware has emerged as the premier home for tech and biotech startups (and many other types of corporations, to be sure).
So what most startups do is incorporate in Delaware, forming themselves as a Delaware corporation. They elect to be taxed as a “C” corporation under the IRC. And then they file a simple form with the state where they actually reside or operate, qualifying themselves to do business there.