A founder, at the outset of starting a company, makes a series of decisions in rapid succession on legal issues that often have far-reaching consequences. Not only is the basis for these decisions rooted in uncertainty (i.e. projections on the trajectories for funding, recruiting, product development, value creation, and avenues for exit), but the underlying considerations are often technical and abstract.
Corporate structure, funding framework, and options plans are three areas that come to mind. Focusing on the decision in the most basic of these— corporate structure — provides a window into how to leverage personal experience along with the input from partners (such as attorneys and accountants) to optimize an expected outcome.
The universe of business structures is nicely finite. Gain Compliance’s anticipated ownership structure — three founders as well as outside investors — quickly narrowed the field to either Limited Liability Corporation or Corporation. We choose the latter. Here’s why:
My first startup was a C-Corp; my next two, LLC structures. So, I’m decently familiar with the attributes of each, and, accordingly, I came into the process this time around with preconceived ideas which I thought were sufficient to make the right choice. But, as the saying goes, you learn something every day. It turns out that I was missing a real, material piece of information. (A nod to Angela Reed, my long-term and favorite accountant, for educating me.)
By way of further background, it’s important to bear in mind the projected path for Gain Compliance. As a software startup, we anticipate generating losses for several years before becoming profitable. Once we have hit this milestone, the upside return for investors will come through a liquidity event such as a sale, and not through a distribution of profits.
Under this set of facts, there’s a decently compelling case to choose the LLC structure:
- Immediate tax benefits for investors. As a member of the LLC, the early investors will receive a K-1 tax form annually which reports their share of Gain Compliance’s gains or losses. As the company will lose money in the early years, investors will be able to recognize, up to the amount of their investment, the losses on their personal returns.
- No double taxation. The LLC structure creates a pass through entity: profits are not taxed at the company level, but rather passed through directly to the shareholders. As such, the IRS only gets a single bite of the apple — at the individual investor level.
Despite this, we opted to become a C-Corp for the following reasons:
- The pass-through nature of an LLC is a double-edged sword. It’s lovely to receive a K-1 with a loss at tax time: an investor’s tax burden is lessened on an investment made sometime in the past. However, when Gain Compliance becomes profitable, it likewise distributes the paper gains, but not necessarily the profits themselves. Companies routinely generate profits, but opt to deploy these in areas other than dividends. So, while investors are initially happy for the tax write-off, I’ll bet their memories are short-lived: they are later equally (or disproportionately) unhappy for an increased tax bill, especially when they do not receive the benefit of the actual cash which accompanied the paper profits.
- Overhead: Gain Compliance intends to run lean. The accounting resources and expertise required to run a pre-revenue, pre-product software company are modest, and there is a real cost involved in accounting for and distributing K-1’s. Personally, at tax time, I hate waiting around for K-1’s, both for timing and the potential surprise. So, given the opportunity to take on the responsibility to generate and distribute them to others, I’ll pass.
- QSBS / Section 1202 — this is where Angela came in. Totally unbeknownst to me, as memorialized in the 2015 PATH law (“Protecting Americans from Tax Hikes Act of 2015”), qualified small business stock holders can exclude 100% of their gains from taxes. That’s (potentially) a big, big deal that dwarfs the other considerations.
The tax implications of QSBS investments are significant: in the event of a sale of Gain Compliance after a five-year holding period, company founders and investors would be able to shield 100% of their gain (up to $10 million, or ten times the investor’s basis, whichever is greater) from any tax consideration.
Interestingly, there’s actually quite a bit of documentation on the QSBS exemption online, but surprisingly little of it includes the 2015 PATH updates. (Here’s a succinct analysis of the benefits.) This is important as, prior to the recent law, the QSBS exemption was being phased out, and only part of the investor’s gains were shielded.
The choice of the company’s corporate structure, like many business decisions, is made in the present taking into account current information and future projections. And ours could very well turn out to be the wrong one: should we fail and all shareholder value is wiped out, an LLC would have been preferable as the distribution of losses would have at least provided some real benefit. Or, if somehow Gain Compliance becomes wildly profitable and distributes dividends, the double taxation implications of a C-Corp would be needlessly expensive. However, in balance, the decision to become a C-Corp is rational based upon the facts and projections as currently known.