Some of the information from a Google search on C Corps vs. LLC’s vs. S Corps will suggest that C Corps are greatly preferred and would lead one to assume that C Corps are the dominant legal entity in the US. However, the facts show the exact opposite. Consider the information below from a 2015 report from the Tax Foundation. Pass-through businesses are basically everything except C Corps – where all taxation occurs only at the owner/shareholder level, not at the Corporate level.
Note the highlighted items below, as well as the charts:
An Overview of Pass-through Businesses in the United States
January 21, 2015
By Kyle Pomerleau
- Pass-through business income is taxed on the business owners’ tax returns through the individual income tax code.
- Pass-through business income faces marginal tax rates that exceed 50 percent in some U.S. states.
- Pass-through businesses face only one layer of tax on their profits compared to the double taxation faced by C corporations.
- The number of pass-through businesses has nearly tripled since 1980, while the number of traditional C corporations has declined.
- Pass-through businesses earn more net business income than C corporations.
- Pass-through businesses employed more than 50 percent of the private sector work force and accounted for 37 percent of total private sector payroll in 2011.
- Although pass-through businesses are smaller than C corporations on average, they are not all small businesses. Many people work for large pass-through companies.
- The majority of pass-through business income is taxed at top individual tax rates.
- Tax reform aimed at improving the competitiveness of U.S. businesses needs to address the individual income tax code due to the economic importance of pass-through businesses.
Sole proprietorships are the most common pass-through businesses – these are simply businesses owned and operated by a single individual or family.
Partnerships in this report includes LLC’s taxed as partnerships, as well as conventional partnerships. While the data is not provided, it is very likely for several reasons that most partnerships in this report are LLC’s taxed as partnerships.
S Corps is the final type of pass-through business.
As shown in the preceding information, it is abundantly clear that C Corps are not the “default” vehicle chosen for most businesses, in fact they are the least common. And, the reason they are the least common is that they are costlier from a tax perspective for the clear majority of taxpayers.
There would be even fewer C Corps were it not for the Internal Revenue Code requirement that publicly traded companies must be C Corps, unless they qualify for limited exceptions such as those for Master Limited Partnerships or Real Estate Investment Trusts.
As we transition to the next discussion, keep a key fact from this data in mind:
- Of all the business tax returns filed in the US, less than 6% are for C Corps! Over 94% of filed tax returns are for pass-through entities or sole proprietors. Accordingly, there are many legal, accounting and tax professionals in the US that are very familiar with tax filings other than C Corps.
Selecting Professional Services Providers – Legal, Accounting and Tax, HR, etc.
We sometimes hear from investors or entrepreneurs that their attorney or CPA “prefers C Corps” or “doesn’t do a lot of work with LLC’s”. If you are hearing that, given that C Corps only constitute 6% of the legal entities in the US, then you likely need to retain advisers that are doing the work for the other 94% of entities in the country. Consider, as well, that virtually every law and accounting firm in the US is organized as an LLC, taxed as a partnership, for many of the same reasons articulated on this site. Thus, one question for any attorney or CPA would be “if your own firm is an LLC taxed as a partnership, why would you recommend something different for my firm”?
Hiring good external advisers should make the choice of legal entity very painless, as they should be very well versed in these matters. Any law or accounting firm that has a substantial practice in the real estate area, for example, would be doing a great amount of work with LLC’s taxed as partnerships as virtually all real estate investments involving multiple investors are organized as LLC’s taxed as partnership. The same for oil and gas investments and many other sectors – including hedge funds, private equity funds, and venture capital funds. So, don’t make your life difficult by using advisers who aren’t experts in the area – there are many to choose from.
Also, consider using an outside firm for your HR needs including payroll, health insurance, and other employment related matters. A firm we have used with our Angel companies is TriNet. These firms are often referred to as Professional Employer Organizations, or “PEO’s”. These firms typically do a tremendous amount of work with LLC’s taxed as partnerships. They can offer participation in large group health insurance plans with many options – and the cost reductions they can provide for insurance may cover the entire cost of their other services (compared to a “do-it-yourself” approach). For a startup, this can greatly simplify your life, and provide to your employees a very professional and complete online platform, like what one would experience at a large company.
Once you select advisers with substantial experience dealing with LLC’s, tell them what your key objectives are. For example, by what date do you want Forms K-1 delivered to shareholders? How soon after month-end, quarter-end, and year-end do you want financial statements available? Will you use cash basis or accrual basis for your financial statements? They can help you with these decisions, and point out other things you might not have considered. And importantly, they can help you build a good execution plan. For example, the books must be closed before tax returns and K-1 preparation can commence. Forms 1099 will likely need to be provided to service providers by January 31 of the following year – what is your plan to have those issued on time? Virtually all the “war story” issues can be avoided, simply by having a good plan, and then executing the plan.
We sometimes hear that “start-ups” are too busy to close the books on time, keep accurate records, etc. in the early years…. but will do it when they have more time and are larger. In our view, those are companies that we should NOT invest in. Running a successful business typically requires planning, execution, and discipline across all key fronts – doing 50% correctly typically doesn’t lead to success. Many items may be outsourced, which takes a lot of load off founders and employees, and that is fine. But the plan needs to be put in place at or before funding, and clear accountability and deliverables established.
Administrative Issues with Pass-Through Entities
Pass-through entities constitute the clear majority of tax filings. However, in the Angel space, some of those are not relevant. Sole proprietorships obviously are not relevant since they do not have multiple shareholders.
As explained elsewhere, S Corps at first blush could be a good fit for startups, but are not often used since they can only have one class of stock (common, but no preferred), are limited to 100 shareholders, and can have no foreign shareholders. Thus, they are typically not a practical vehicle for startups, despite their otherwise tax efficient attributes.
That narrows the 96% of pass-through entities to just one category – those taxed as partnerships – for purposes of start-up companies. For legal liability and other reasons, typically an LLC electing to be taxed as a partnership will be utilized, although a conventional partnership is a possibility if it were desired for some reason. For the subsequent discussion, let’s assume we are always using an LLC, electing to be taxed as a partnership.
So, what are the primary issues that we hear about regarding operating as an LLC vs. C Corp? That can vary greatly from individual to individual, based on their background and other investments.
Many investors are already quite familiar with LLC’s as the following investment options are virtually always housed in LLC’s taxed as partnerships for all the reasons explained on this site:
- Investments in a Private Equity and Venture Capital firms/funds
- Investments in any type of Hedge Fund
- Investments in virtually any kind of private real estate venture
- Investments in virtually any kind of private oil and gas venture
Thus, many accredited investors with broad investment portfolios will have often encountered LLC’s taxed as partnerships, and have received many K-1’s reporting their tax information over the years.
But, often newer accredited investors, or those that have not invested as broadly in the past, may not be familiar with LLC’s taxed as partnerships.
Concerns that are expressed include:
- What if I don’t receive my K-1 in time to finish my taxes by April 15? (Or, for an Angel Fund, how do I assure that I receive portfolio K-1’s or estimates in time to at least give my Fund investors a good estimate of what the Fund K-1 will look like, by April 15?)
- What about State Income Taxes that may be due in States other than where I reside?
- If I am an employee or Director, how do Profits Interests Units (“PIU’s”) work (the LLC corollary of a C Corp stock option)?
- Holders of LLC units, including PIU’s, cannot be treated as employees of the LLC for payroll tax purposes. Accordingly, employment taxes and income taxes are not withheld from their “salary” payments…which are referred to as “guaranteed payments” in LLC parlance. Isn’t that a problem? How are those amounts paid by holders of LLC units, including PIU’s?
- What if income is reported on a form K-1, but I don’t receive any cash to pay the related tax?
- Isn’t it just simpler to have a C Corp?
Let’s address the last question first, with a common and perhaps not too satisfying answer – “It Depends”. If someone has no background with LLC’s and K-1’s, then a C Corp will naturally seem easier initially, since there is nothing new to learn or understand.
Conversely, though, those that already receive many K-1’s from other investments will likely not perceive an issue. For example, one of the authors of this material received approximately 20 K-1’s for the 2015 tax year, and only 2 of those related to Angel investments – 18 others were from hedge funds, real estate partnerships, etc. Adding more K-1’s in a fact pattern like that is typically of little or no consequence.
Also, one should recognize that there are situations where C Corps are more complicated than LLC’s. A classic example the authors have encountered, is the application of Section 1244 – the special provision whereby the first $1M of equity invested in a company that fails can be claimed as an ordinary loss rather than a capital loss. While your CPA may well ask you if you have any Section 1244 losses, even if you know that you qualify, odds are you don’t have the computation of the proper amount for your tax return. Further, if your CPA must obtain all the data and do the calculations himself, it could be inordinately expensive – and each investor would have to do the same thing repeatedly. Keep in mind in situations like this the management is probably gone, attorneys may not provide information without paying them, etc. since the Company has ceased to exist or been acquired at a loss by another company.
By comparison, with an LLC structure the losses in a failed company will automatically be ordinary losses not subject to any limitation. And, those losses were calculated and reported each year as incurred. Thus, there is no equivalent of a complex Section 1244 calculation that is needed. So, from a practical tax complexity standpoint, C Corps should not be assumed to be more “investor friendly” than LLC’s.
Notwithstanding that, let’s assume for purposes of discussion that an investor considers the use of an LLC, and receipt of a K-1 as additional complication, possibly increased tax return preparation cost, and simply something they would prefer not to deal with. Is there anything else they should consider?
Yes, by analogy, this situation is much like an individual taxpayer choosing to itemize deductions rather than claim the standard deduction. To itemize deductions taxpayers must keep many more records regarding medical, real estate tax, property tax, charitable contributions, investment expenses, etc. And, they will pay more to have their tax return prepared, or spend more time preparing it themselves, since they must complete Schedule A of Form 1040 to itemize deductions.
So, why do any of us bother to itemize deductions – why not keep it simple and take the standard deduction? Of course, it is because we don’t want to pay more taxes than we are legally obligated to pay, and in virtually all cases the savings from itemizing deductions will greatly exceed the incremental cost. So, basically the benefits greatly exceed the cost – a rationale economic decision.
The same is presumably true with those that view K-1’s or LLC’s generally as more bothersome, time consuming, costly, etc. If that is the case, is one willing to incur those costs if the benefits are sufficiently greater…. or would they take the position, by analogy, “I don’t want to itemize deductions no matter how great the savings”? Let’s presume most investors would make that judgement based on cost vs benefit.
Therefore, the ultimate question seems to be “how much does it cost vs. the benefits I am receiving”? This is where the clear majority of the information we have seen on websites falls short – typically no attempt is made to quantify cost/benefit trade-offs – implicitly assuming there are no benefits, which is obviously not the case in most circumstances.
First, let’s consider what unfortunately happens to over 50% of startup businesses – they fail.
One of the authors’ initial Angel investments was in a follow-on round in a C Corp, which then failed within a couple of years. The investment did not qualify for Section 1244 ordinary loss treatment, and therefore the loss would likely only provide a 20% tax benefit at some future point in time offsetting long-term capital gains.
In a discussion with another investor who had invested $100,000, the author said something like “sure disappointing we weren’t formed as an LLC”, to which the investor’s first response was something like “I don’t care, LLC’s seem more complicated to me – like simplicity”. Suspecting the investor didn’t realize how much that simplicity had cost, the question was then posed whether the simplicity of being a C Corp for a couple of years was worth $20,000? Naturally, the investor was very surprised to learn that the equivalent of a car for one of the kids, had been lost simply by not using an LLC vs. C Corp for that investment. And when over 50% of Angel investments end up out of business, one can quickly see how doubling the tax recovery on the loss can be hugely significant across a portfolio.
Let’s look at another dimension of the issue- what if you simply pay an attorney or CPA to handle every additional complication for you. Could you possibly pay more than you would receive in benefits from an LLC structure?
That is exceedingly unlikely, except for very small investors. Any incremental costs are likely “fixed costs” – i.e. they are the same regardless of the size of investment. Purely hypothetically, assume an investment of $5,000 and incremental annual costs of $200. That is 4% of the investment amount…but for a $25,000 investment is only 0.8%, and for a $100,000 investment is very minimal. Naturally, one should make the cost/benefit comparison, but except for very small investors it is likely going to show a very wide margin in favor of the LLC structure.
How do we get our Tax Information on time?
One concern raised a lot is timely receipt of tax information, reported on Form K-1, so that individuals can file their tax returns. This concern is amplified for funds who need to receive K-1’s from portfolio companies, to then prepare K-1’s for their fund investors.
So how can you assure that K-1’s are issued on time, certainly no later than the IRS deadline? It is like many other things in business, planning and execution. Our observation is that the primary reason tax information is not issued on a timely basis, or contains errors when first issued, is due to the books of the Company not being closed in a timely and accurate basis at year-end. So much of the accounting and tax reporting is automated, that if the books are properly closed on a timely basis, there is no logical reason that the LLC Partnership Tax Return and the related K-1’s should not be available shortly thereafter.
Investors typically expect that each company they invest in will keep accurate and timely financial records. That is usually required in the governing legal documents and should be monitored/enforced by the BOD. And not just for tax return purposes, more importantly so that management, investors, and the Board have accurate, timely historical information and forecasts with which to manage the business. In many of our LLC deals, we see delivery dates for tax information set forth in the legal documents which are before the legal deadlines set by the IRS.
If you are a Board member, do you ask your management team in November/December for their plan to close the books promptly and accurately at year-end, and for the prompt preparation of tax information? If not, why not? This is basic blocking and tackling, but like anything if there is not a plan and a focus on execution, it won’t cross the finish line on time.
OK, but what if execution of the plan fails for whatever reason, and K-1’s are late or inaccurate. If that happens, it is more likely to occur early on – perhaps the first year or two. There are a couple of mitigating factors with the normal fact pattern.
Very few startups make a profit for the first few years….and over 50% will likely go out of business without ever generating a profit.
During that time from inception to making a profit, or going out of business, there will likely be no income on which to pay tax, only losses reported to investors.
For investors not on the Board or otherwise very actively involved in the business, it is likely those losses will be considered “passive losses”. Those losses can only be used to offset passive income, and if an investor doesn’t have other passive income, the loss will just carryover to future years. Thus, receipt of a timely K-1 may have no impact on that person’s income tax in that initial loss year. If the Company subsequently goes under, the prior passive losses will be fully deductible at that time as an ordinary loss – not a capital loss.
Another offset to a “failed execution plan” hinges on the profile of your typical investor. Many accredited, broad-based investors who invest in numerous hedge funds, real estate ventures, etc. never attempt to file their tax return by April 15, but rather obtain an extension of time to file until October 15. One must have a reasonable estimate of their tax liability by April 15 so that they are not underpaid, but these taxpayers are used to this and they, or their CPA, simply maintain a reasonable estimate of their ultimate tax liability. There are good reasons for investors to consider following this approach of filing an extension to October 15 for filing your income tax return:
- Often a “Fund of Funds” (an investment vehicle, e.g. hedge fund which in turn invests in numerous other hedge funds), will tell their clients that they will provide estimated tax information by April 15, but have no plan to deliver K-1’s until after April 15. Thus, investors in those types of vehicles already have no choice but to extend their tax return, so late K-1’s from other companies are of little or no concern.
- It is not unusual for Form 1099’s, in addition to K-1’s, to be delivered late – or to be subsequently revised close to the April 15th deadline…or not long after. This happens even with the very large and well established brokerage houses. After all, companies and CPA’s are working around the clock for the 3 months prior to April 15, and it is easy to make mistakes working under that kind of time pressure, and sometimes not possible to correct the mistakes and communicate with investors before April 15. By extending your tax return filing date, you may avoid subsequently filing an amended tax return.
- If you are an upper income taxpayer with a more complicated return, would you rather have your CPA complete it when they are fresh and not under a time crunch, or when they are working 24 x 7 prior to the April 15 initial filing date? Giving your tax preparer more time for complex returns, may be a good idea which could save you time and money, in addition to avoiding stress.
Many larger Angel investors probably fall into this category and already extend their individual returns. But smaller investors may not extend returns. If so, they will be more sensitive to the Angel Company executing their plan and delivering information on a timely basis.
What about State Income Taxes?
Since Texas has no individual income tax, a question we frequently hear is “what if the company does business in other states – what are the tax consequences”?
If a Company has what is referred to as “nexus” in another state, that will typically cause filing requirements in those states. Nexus typically means having a presence in the state in terms of employees and/or physical facilities. Typically, just selling to customers in a state where there is no such presence, will not subject the Company to state income tax filings in that state (e.g. if the only facilities and employees are in Texas, and products are sold online and shipped by common carrier to customers in other states, typically that will not subject the Company or shareholders to income taxes in other states).
But what if there is nexus and a requirement to file? Many states, with the notable exceptions of NY and CA, permit the LLC to file on behalf of the shareholders. Thus, for many states that issue is quickly solved – and the state process is very similar to a C Corp.
However, NY and CA and potentially a few other states will frequently not allow the Company to file on behalf of the individual. Since NY and CA are generally viewed as very expensive states in which to have a presence, and often avoided by many companies for cost and regulatory reasons, many startups may not be subject to income taxes in those states. However, some undoubtedly will do more than “drop-ship” to NY or CA, and will be subject to filing requirements – assuming the businesses succeed.
Focus once again, though, on the unfortunate fact that roughly 50% of Angel startups don’t survive – and are typically out of business within three years. And if they are going out of business, they won’t be generating any taxable income but rather only losses. Thus, if an investor does not already file in NY or CA, and they only have losses reported on a K-1 for those States, they are likely not even required to file in NY or CA. And if that company goes out of business, they will have guaranteed an ordinary loss – likely worth twice as much on their federal tax return as a capital loss – roughly 40% recovery vs. 20% recovery. Accordingly, there is little or no downside to having an LLC during loss years from a NY or CA taxation perspective.
If the business is a survivor, and ultimately generates taxable income in NY or CA, then returns would have to be filed by all investors. However, it is very likely that any incremental costs would still be more than offset by other benefits as explained elsewhere on this site. However, if a majority of the shareholders concluded that they wanted to convert to a C Corp to eliminate NY and CA K-1’s and related filings, that can be done at no incremental tax cost, once the Company is generating taxable income in those states. Thus, once again, there is essentially no downside to forming first as an LLC and operating in that format as long as desired, since there is always a “no tax cost” exit option. The reverse is not true – once in a C Corp one is likely trapped, as the tax cost to convert to an LLC will likely be insurmountable.
Selecting Legal and Accounting Partners
Running smoothly with an LLC structure should not be a major hurdle. As explained previously, far more businesses operate as LLC’s and other forms of pass-through entities than C Corps. Thus, it follows, that there are many very qualified law and accounting firms that know how to handle LLC’s taxed as partnerships. And, in fact, virtually all law and accounting firms are themselves, LLC’s taxed as partnerships.
Occasionally we hear comments like “our attorney, or CPA doesn’t like LLC’s and would rather use a C Corp”. If you hear those comments, without any rationale comparison of costs/benefits…grab your wallet and run for the door.
When considering law and accounting firms to retain, ask them how much LLC and partnership work they do in their practice. If they don’t do a lot of it…move on to another choice.
Many firms will do a high volume of LLC/partnership work, for example those that do a lot of real estate work. There are more firms with this expertise than there are without it, so don’t waste time dealing with firms that don’t have that experience and focus.
Profits Interests –the LLC equivalent of a C Corp Stock Option
Another item that often raises initial concerns is that an LLC equity option, referred to as a Profits Interest Unit, or “PIU”, has a few differences from a C Corp Stock option.
There are many similarities – starting with the basic concept that a stock option or PIU are both designed to provide value to the holder only if the company increases in value in the future. They are both typically granted at the current value per share/unit, and therefore have no value unless the value per share/unit increases in the future.
From a tax perspective, PIU’s offer far better results in most cases vs. a C Corp stock option, regardless of whether the C Corp stock option is the most commonly granted non-qualified stock option (“NQSO”) or the less common Incentive Stock Option (“ISO”). Few public companies issue ISO’s, although some private and typically very small C Corps continue to issue them, perhaps because they don’t fully understand all the implications.
To illustrate the differences, let’s assume a simple example of 1 stock option or PIU granted at a strike price of $10 Per Share. Let’s assume that the firm appreciates in value and is acquired at a price of $50 Per Share, 4 years after the grant date. The holder of the option or PIU would have a $40 gain before taxes, but what about after taxes? Let’s also assume the holder is subject to long-term capital gains tax at a rate of 20%, ordinary income tax at 40%, and Alternative minimum tax (“AMT”) of 28%.
PIU from an LLC: 20% LTCG tax on $40 gain = $8, clear $32 NQSO in C Corp: 40% ordinary tax on $40 gain = $16, clear $24 ISO in C Corp: Probably doesn’t apply since must hold shares for a year after option exercise, but if could meet requirements would have a $40 AMT Preference Item, which could drive tax of $40 x 28% = $11, plus would owe LTCG tax on $40 of $8, thus clear $21. And even if not impacted by AMT, would have to hold the stock a year longer to get the same result as an LLC PIU.
Thus, a PIU is superior from a tax and flexibility perspective to either “flavor” of C Corp stock option.
PIU Holders receiving K-1’s rather than W-2’s
Some have said “but PIU’s are harder for employees to understand, and if they are granted a PIU, then they start receiving Form K-1’s rather than Form W-2”.
While that is the general rule, there is one option that can be deployed to eliminate that issue, which is a properly structured two-tier LLC. However, many may view that as an additional cost and complication that is not necessary – but it is available, if desired.
Absent the two-tier LLC solution, if one is granted an equity interest in an LLC, that person will start receiving a Form K-1 each year. The K-1 will report essentially what was Gross Wages on a Form W-2, but labeled as a “Guaranteed Payment” on Form K-1. Income, Social Security and Medicare taxes are not withheld by the LLC, so the PIU holder will pay those directly.
But, all that is happening with holders of PIU’s, is that they are being treated as if they were self-employed individuals. As explained in the introduction to this section, 73% of businesses in the US follow this model. Every consultant, law firm partner, accounting firm partner, etc. is treated in the same manner – as self-employed. So, this is extremely common. Self-employed individuals will need to make estimated income tax payments – at most 4 times per year – and pay Self-Employment Tax (includes Social Security and Medicare) as part of filing their Form 1040 each year. The net result is essentially the same as being an employee who receives a W-2 and has income and Social Security and Medicare taxes withheld from their salary.
Our experience with actual employees of LLC’s is that if they have never had PIU’s before they may be initially confused or concerned that it is different from a C Corp stock option. But, once they understand that conceptually it is basically the same thing, except that on an after-tax basis it likely will keep an incremental 20% of a future gain in their pocket, instead of going to the US Treasury, it is viewed as a positive feature – not an issue.
Consider, also, that virtually every law and accounting firm is organized as an LLC taxed as a partnership, and they use PIU’s continually to admit new partners to their firm. So, the level of understanding of what PIU’s are and how they operate is very deep.
What if I receive a K-1 reporting income, but don’t receive any cash to pay the tax?
Good question, which should be addressed in the LLC Operating Agreement when the company is funded. Typically, a requirement is simply included in the Operating Agreement to distribute cash to investors in an amount necessary to cover any related tax. Keep in mind that the taxable income or loss for a given year, or cumulatively to any point in time, will be the same whether an LLC or C Corp houses the business. The primary difference is who pays the tax, and what tax rate is applied to the taxable income. Thus, if a business would have needed to pay income tax to the IRS if it were a C Corp, it will not owe income tax if it is an LLC. The cash that would have been paid to the IRS from a C Corp, is merely distributed to the LLC investors who pay the tax to the IRS.
Typically, the operating agreement for the LLC will require that cash be distributed to investors assuming the highest marginal tax rates (for both Federal, and if applicable, any States), so that sufficient cash will be available to investors to pay the related income tax.
There appear to be rather widespread beliefs among startups and Angel investors, that C Corps are the predominant legal structure in the US. Yet C Corps constitute less than 6% of the businesses in existence in the US, and their presence has been declining for years while use of pass-through entities has steadily increased. Many of the largest businesses are C Corps, but simply because they have no choice. With very few exceptions, the Internal Revenue Code requires publicly traded companies to be a C Corp – for obvious reasons, it results in much higher tax revenue for the US Government.
Similarly, there often tends to be a perception among startups and Angel investors, that use of pass-through entities like LLC’s introduces complications, unknowns, and uncertainties in operating the business. Yet the clear majority of businesses operate in this space, not as C Corps, and there are vast resources available to assist with operating a business in this format.
And, perhaps most importantly, pass-through businesses generally provide the greatest amount of optionality. At any time in the future a business can be converted to a C Corp, if desired – it is even “encouraged” by our tax code which imposes no incremental cost on such a conversion. Conversely, “once a C Corp, always a C Corp” …. The tax “toll charge” to convert to an LLC will preclude most conversions. Thus, the inherent US tax policy is to “trap” taxpayers in C Corps for obvious reasons – to provide more tax revenue.
So, at the end of the day, this seems to come back to the analogy of “do you itemize deductions if it reduces your taxes, or prefer to pay higher taxes to gain the simplicity of the Standard Deduction”? Neither decision is inherently right or wrong, it is merely a cost vs. benefit decision.
The benefits of a pass-through/LLC approach are economically very substantial, especially for larger investors, so it seems likely most larger investors will be in favor of pass-through/LLC approaches. They are also likely to have already invested in them outside the Angel arena via hedge funds, real estate investments, etc. Any incremental administrative costs are likely minimal relative to the benefits.
Investors of smaller amounts, or Funds which are comprised largely of smaller investor amounts, might conclude they are willing to accept lower returns if they believe a C Corp structure is easier for them. While the reduction in their returns on a % basis could still be very large, they might conclude that the dollar amount of the reduction is palatable.
Finally, it does seem that a decision to use a C Corp should not be based on the premise that it avoids a host of difficult and complex issues, that can’t be managed by competent professionals and company management. The vast majority of businesses operate today in other than C Corp format. If anything, C Corps are the outlier in terms of legal entities in use in the US. Thus, our view that pass-through/LLC should be the rebuttable presumption for preferred legal entity for startups, especially since one can change later. Jumping to a C Corp structure at formation, with no bridge back, should arguably only be done after very careful evaluation…not be a default option.
Next Section: About the Authors/Sources of Information
All materials have been prepared for information purposes only. Fact patterns can vary, and changes in law and other authorities may occur over time. You should consult with your accounting/legal advisors before implementing any legal/tax structure.