tl;dr: If you are a startup founder who wants an acquisition, then you probably want to form your company as a C-Corp. This might save you a crazy amount of money on federal and state taxes due to Qualified Small Business Stock.
There are very few things that I regret about how I ran my last startup, Beat The GMAT: my team bootstrapped a highly profitable business over multiple years; built a product that helped millions of people achieve their higher education dreams; and fostered a team culture that was close-knit and fun.
But I do have one serious regret: forming my company as an Limited Liability Company (LLC) instead of a C Corporation (C-Corp).
This little business decision cost me a ton of money when my company got acquired. The reason why: Qualified Small Business Stock (QSBS).
The purpose of this article is to make you aware of QSBS and its potentially massive benefits to startup founders. QSBS is just one factor to consider when selecting a corporate entity type (C-Corp, S-Corp, LLC, Sole Proprietor, etc) for your startup. Talk to a startup attorney about this stuff to get the right guidance.
A cursory introduction to Qualified Small Business Stock
Let’s say that your company gets acquired (hooray!). If you have a choice between paying federal taxes on your gains, vs. not paying federal taxes — which would you pick?
You probably wouldn’t want to pay any taxes, right?
Well, if you were a startup founder who set up your company as a C-Corp and met a few simple conditions, then your shares could be regarded as Qualified Small Business Stock (QSBS). QSBS allows you to exclude a lot of taxes owed from the gains you make when you sell your company.
What are the conditions you need to meet for Qualified Small Business Stock? Fred Wilson from Union Square Ventures has a nice summary of QSBS. To quote from his article:
GENERALLY, To qualify as QSBS, the stock must be:
- Issued by a domestic C corporation with no more than $50 million of gross assets at the time of issuance;
- Issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than in certain personal services and types of businesses described in more detail below;
- Issued after August 10, 1993;
- Held by a noncorporate taxpayer (meaning any taxpayer other than a corporation);
- Acquired by the taxpayer on original issuance (there are exceptions to this rule); and
- Held for more than six months to be eligible for a tax-free rollover under Sec. 1045 and more than five years to qualify for gains exclusion.
With QSBS, you typically would be able to exclude 50-100% of your gains for federal taxes. The exact amount which you can exclude varies from year to year, depending on where Congress decides to set the limit. With many states, there is often exclusion with state income taxes on gains as well.
So why does QSBS exist?
Well, it turns out that when politicians make lofty statements like “small businesses are the engine of America’s economy,” they are actually telling the truth. Entrepreneurs are huge drivers of jobs, wealth, and consumption in the United States. Thus, Congress wants to create incentives for people to become entrepreneurs. But for some reason, Congress only applied QSBS to C-Corps and did not include other corporate structures (LLC, S-Corp, etc).
When I sold my company in 2012, I would have been able to exclude 100% of federal taxes on my gains had I originally formed my startup as a C-Corp instead of an LLC. But instead I enjoyed no exclusions and was taxed at the full federal capital gains rate (15% back in 2012; as of 2014 it’s 20% + 3.8% for Obamacare).
QSBS is a pretty sweet deal, so why did I do an LLC?
When I formed my company in 2007 I had no knowledge of QSBS. Had I known about it, I would have definitely formed a C-Corp.
Ironically, I decided to go with an LLC because I thought it would simplify my tax situation. And arguably it does. When you have an LLC you can do something called pass-through taxation, where the income you earn based on your share of the company flows directly into your personal income reporting for taxes.
Here’s an example:
Let’s say that Jane owns 70% of an LLC, and Becky owns the remaining 30%. Let’s say their startup earns $100,000 for the year with miraculously $0 in expenses. With pass-through taxation, Jane would be able to report $70,000 in earnings for her tax filings and Becky would report $30,000 in earnings for the year. Simple and logical, right?
Using this same example, let’s say that Jane and Becky have a C-Corp instead. Now Jane and Becky would face a double-taxation situation. Their company would have to report its own earnings to the government, just like another human being. And Jane and Becky’s own earnings do not pass through the C-Corp; they need to set their own payroll wages and report only what they decided to pay themselves for the year, which doesn’t necessarily have to align with their proportional share of ownership in the company.
I liked the simplicity of pass-through taxation, so that’s why I opted for an LLC.
To conclude, founders generally should do a C-Corp
If you are a startup founder who is interested in an acquisition at some point, then a C-Corp is probably the way to go. If you don’t ever want to sell your company, then perhaps having an LLC is fine, although that closes the door on QSBS benefits in the future if you change your mind and want to sell later.
Talk to your startup attorney about what’s best for your company. C-Corps, LLCs, and other corporate entity types each have their own pros and cons beyond taxes, which could potentially trump even QSBS benefits when you sell. Your attorney can guide you to the right choice.
If I can clarify anything in this article, please leave a reply and I will follow up.
A special thanks to Sima Gandhi, a former tax attorney at Simpson Thatcher, for reviewing this article. Also, thanks to Beatrice Kim for helping me figure out my crappy illustrations for this article.