Investment Return Illustration: LLC vs. C Corp
Let’s walk through an illustration to show the potential impact on investor returns, solely related to choice of legal entity.
Let’s start at one extreme. This is not an unlikely fact pattern; it is simply the worst that can happen. There will be circumstances where at least a portion of this adverse impact may be mitigated, and we will discuss those later. But to become oriented to the potential magnitude and significance of legal entity choice, consider the following simplified example.
Assume Angel investor invests $200 in various angel companies.
National stats suggest at least 50% of angel companies go bankrupt within the first two or three years. Thus, assume that $100 of the $200 investment is a total loss.
Assume, though, that the other $100 invested produces a net return of $500, or on average 5X the $100 originally invested.
So, let’s summarize where we stand, on a pre‐tax basis:
C Corp Tax and Economic Analysis
Now, let’s look at the worst case result from a tax perspective for a C Corp, which unfortunately has a relatively high probability of occurring.
First, it is not unlikely that an acquirer will insist on buying the assets of the company rather than the stock. Thus, they buy what is INSIDE the company (i.e. the “assets”), but not the stock of the Company itself. The Company receives the sales proceeds directly from the buyer, incurs and pays the Corporate level tax from the gain on the sale of the assets, pays off any remaining liabilities, and then distributes the remaining cash to shareholders in complete liquidation of the Company.
There are two primary reasons for a buyer to prefer an asset purchase over a stock purchase.
(1) Young companies often have unknown liabilities that are impossible, or extremely time consuming, to quantify. For example, young companies often don’t have sophisticated systems and may not have paid sales taxes to the correct jurisdictions or may have failed to collect them at all when they should have. If sales taxes average 7% of revenue over all prior years, a very large liability can be created, and often taxing authorities don’t discover or assert deficiency’s until several years after the fact. Or, perhaps a company has unknowingly infringed IP of another Company, and it has not yet been discovered or asserted by the other company. Especially if the acquirer is a large company, they can easily be viewed as “deep pockets” for a subsequent IP infringement assertion, whereas the smaller company may have been viewed as not worth chasing. An acquirer can totally avoid these risks by buying the assets (again, the contents of the Company, but not the stock and legal entity). If a subsequent claim arises, it can typically only be asserted against the former C Corporation – which the acquirer did not purchase.
(2) If an acquirer purchases assets rather than stock, they can deduct 100% of the purchase price for tax purposes over subsequent years – the longest possible write‐off period is 15 years, and much is often written off over 5 years or less. For a Company paying Federal and State Corporate income tax of roughly 40%, on a nominal basis that lowers the purchase price of the Company by 40%. Conversely, if the acquirer purchases the stock of a C Corp, it can only write off what was inside the Company when they acquired it – not the amount they pay for the stock. So, to illustrate, assume Angel Company has $10 of assets or loss carryovers inside a C Corp which will benefit an acquirer. Further assume, though, that they are paying $100 to purchase the stock of Angel Company. The acquirer can only write‐off $10 in the future, which only saves the acquirer $4 vs. purchasing assets where the acquirer can write‐off $100 and recover $40.
So, what happens if the acquirer purchases assets rather than stock? First, the sales proceeds go to the Company, which must pay tax on the gain at a 35% federal tax rate – and more if they must pay state income taxes, as well. Then, the remaining cash in the C Corp after paying the IRS and other creditors, is distributed to shareholders who (absent exceptions discussed subsequently) will pay tax again at a 20% rate (plus potentially the 3.8% Net Investment Income Tax). While the two tax rates added together are 55% (plus state taxes, if any, on top of that), because paying the IRS 35% tax at the C Corp level reduces the amount of cash left to distribute to the shareholders, the math works out that the combined all‐in tax rate is roughly 50% of the pre‐tax gain (slightly less than 55%), but still very painful.
So, is that all the potential bad news on the C Corp taxation front? Unfortunately, no – let’s now talk about the $100 investment in this example that was a write‐off. How much can a C Corp investor recover on this loss?
Absent a special provision discussed later, which is often limited or doesn’t apply at all, probably the most an investor will recover is 20%. The reason is that a loss from a C Corp stock write‐off is normally a capital loss. As you probably know, except for $3,000 per year, an individual can only utilize a capital loss to offset capital gains. Capital losses can be carried forward indefinitely, but require a capital gain for offset. Thus, if you have no capital gains to offset, the most one can deduct is $3,000 per year. And if you do have capital gains to offset the loss against, there is a good chance that they are long‐term capital gains that would only have been taxed at the special 20% rate, in which case your C Corp stock loss is only worth 20%. Only if you have short‐term capital gains to utilize the loss against, could you obtain a higher tax benefit of up to approximately 40%. For purposes of this example, we will assume middle of the road – a 20% tax benefit on the loss.
So, now let’s look at our example again, with the C Corp tax costs:
Note the significant reduction in returns, once taxes are taken into consideration.
LLC Tax and Economic Analysis
Now, let’s look at the same set of facts, before tax, but with the Angel Company being an LLC, taxed as a partnership, rather than a C Corp.
First, let’s assume for the reasons discussed above, that the acquirer wants to purchase the assets inside the Company rather than stock – it doesn’t matter. Unlike a C Corp there is no tax at the LLC level, and only the 20% tax paid by shareholders. Thus, 30% tax leakage is eliminated.
Further, if the acquirer wishes to purchase the stock of the LLC, rather than assets, the acquirer can do so and write‐off the ENTIRE purchase price subsequently, which could not be done if C Corp stock was purchased. Thus, use of the LLC completely eliminates the tension that exists between the seller and the buyer in a C Corp transaction, and buyer should always be willing to pay far more for the stock on an LLC than the stock of a C Corp.
It is critical to realize that in a typical C Corp transaction, someone has to take a meaningful tax and economic hit – it is only a question of whether it will be the buyer or the seller. And the IRS is always the winner in a C Corp structure. If the seller avoids two levels of tax, the buyer cannot write‐off the full purchase price. And if the buyer can write‐off the full purchase price – and avoid unwanted liabilities – then the seller is going to have a 50% rather than a 20% tax rate. C Corp structures typically create Win/Lose scenarios between buyer and seller – and there is no solution for that issue. An LLC structure is a Win/Win between buyer and seller and eliminates adverse interests.
Now, let’s look at the tax treatment of LLC losses. Unlike a C Corp, as losses are incurred they are not trapped within the C Corp but rather each investor is allocated their share each year which enters into their individual tax return. And these are ordinary losses, NOT capital losses – so they are not limited to use only against capital gains. For many taxpayers, the losses may not be immediately deductible due to some other complicated tax rules referred to as the Passive Loss Limitations, but they carry forward indefinitely to future tax years. And, in the year that a Company goes out of business, the entire amount of such losses is fully deductible as ordinary losses. Thus, since many Angel investors have relatively high incomes, those in a 40% tax bracket will receive a 40% tax benefit from those losses.
So, let’s look at our example again with LLC tax results:
Now, let’s look at the C Corp and LLC results, After‐Tax, side by side:
In this example, the tax cost of the investments was reduced from $230 to $60 from utilizing the LLC structure. That resulted in a gain, after‐tax, that is twice that of the C Corp ‐ $340 vs. $170 in this example. And the nominal return doubled from 85% to 170%.
Let’s focus on this difference in a little more depth. These obviously are not single year returns, but happen over a period of years. A lot of Angel data suggests many good exits don’t occur for well over 5 years and maybe closer to 10 years out.
So, for discussion, let’s say this example had played out over 10 years, and if we simply divided the nominal returns shown above by 10, then the C Corp example would have averaged 8.5% per year, and the LLC example would have averaged 17% per year.
Now, let’s think about this from an investor perspective. What do most large mutual fund groups, investment advisers etc. typically tell us that we can expect to earn on a good portfolio of large cap, lower risk equities? Typically 8% to 10% on average – the S&P 500 has averaged 10% over long periods of time (7% adjusted for inflation).
So, if we are disciplined investors and know that Angel investments are the highest risk equity investment class, and if we knew that expected returns were, on average, 8.5% per year….would we continue to invest in Angel companies or conclude we should put our money in an S&P 500 index fund where we can obtain the same likely return with far, far less risk?
With the LLC example, at 17% average annual return, at least there is a logical argument that the return level warrants the incremental risk.
And, setting aside the S&P 500 and asset allocation, risk/return analysis, etc – why would one ever want to invest in a business under one legal structure, if the same identical business in a different legal structure could double the after‐tax returns?
Now, are there exceptions to the extreme disparities portrayed above?
Yes, in some circumstances there are some offsets, but they are likely best thought of as “partial damage mitigations”.
As explained below, there are plenty of cases where none of them will apply. And there are cases where the limitations on their use will be greatly exceeded by investors and founders so that even if they apply, they provide only limited relief. And, there are cases where even if they do apply, because of the harm they do to the acquirer, most acquirers will simply pay less to acquire the company – so if you could be in the acquirer’s deal room you would see that what you thought you gained by qualifying, was actually more than given up via lower purchase price.
Thus, the following are typically looked at in the context if one finds themselves trapped in a C Corp downstream, you want to consider all these provisions to see if they can provide some relief. But the chance that they will take your tax and economic results back to where a LLC would have been, is exceedingly slight – and a large gap is likely to still exist.
OK, so let’s examine those potential exceptions:
Section 1202 of IRC
Section 1202 of the Internal Revenue Code (“IRC”) – this section provides that if Qualifying Small Business Stock (“QSBS”) is held for over 5 years, that some portion of the gain on sale will not be taxable. The % exclusion has ranged from 50% to 100% depending on the year of initial investment, the provision has expired several times and been renewed by Congress. Given the somewhat tumultuous history of this provision, it may be risky to assume it will continue to exist into the future, but let’s set that aside.
Here are the potential issues:
- Must have held stock for 5 years, if exit in less than 5 years, doesn’t apply
- Can’t apply to more than $10M of gain – that is a large number, but on very successful exits can be a factor for founders and large investors
- Even if otherwise qualify for Section 1202, If the buyer refuses to buy stock, and rather insists on buying assets, 35% incremental tax is incurred at C Corp level vs. only 20% with LLC.
- The main issue is that in order for the seller to benefit, in most cases the buyer has to take a hit…and likely a larger hit…than what the seller gains. Focus on this key fact via example – assume Company sells for $100 and the tax basis is $10, so seller has potential gain of $90 – 9X. Section 1202, if operative, can reduce by 50%, or eliminate entirely, the tax on that $90 gain (depending on what year the original investment was made). And how much tax is being eliminated? 20% long‐term capital gain tax, at most, or $18 in this example.
- Now, let’s jump to the buyer’s side of the equation. If the buyer purchases stock, then the buyer can only deduct $10 of the $100 purchase price. This is the Win/Lose dichotomy for which there is no path around with a C Corp. So, for the seller to gain 20% of $90, or $18 in tax savings, the buyer has to give up $90 in tax deductions….but the buyer’s tax rate is probably 35%, so that costs the buyer $31.50. This creates “negative arbitrage”, in that what benefits a taxpayer on one side of the transaction, costs the other party more.
- So what is likely to happen in a fact pattern like this with a knowledgeable buyer? While the seller will probably never know unless they engage in a direct discussion with the buyer on this specific topic, any informed buyer will simply offer a lower price for the Company if they buy the stock, to offset the adverse tax consequences to them. The problem, though, as illustrated in this example, is if they lower the purchase price by $31.50, now Seller’s gain is only $90 less $31.50, or $58.50. If Seller had maintained the $90 gain, and paid 20% tax on that, Seller would have cleared $72…more net proceeds after tax than what was obtained via Section 1202.
Section 1244 of IRC
This provision potentially allows losses from investments in QSBS stock to be treated as ordinary, rather than capital losses. As such, losses would then potentially produce roughly a 40% tax benefit equal to that produced by the LLC structure.
However, the issues with this provision are:
- Only applies to first $1M invested, and we see even seed rounds above that amount, not infrequently. And subsequent rounds are likely to not qualify at all, since that threshold has been exceeded.
- Only $100K on a joint return, $50K on a single return, can be deducted in a single tax year. Larger investors will often exceed those limits.
- Thus, these provisions would likely only provide benefit on a reliable basis for smaller investment amounts, investing in smaller deals, and investing before the $1M threshold is met.
- While 50% or more of deals go south, one never knows which ones they will be. So if a C Corp structure is used and one carefully makes sure their investment meets the requirements of Section 1244, but then that Company is sold at a profit in an asset sale where 50% tax is incurred…the investor has lost.
- Thus, when an ordinary loss can be virtually assured by forming as an LLC, regardless of the amount invested in the Company, and regardless of the size of an individual investor’s position, and all the positives of a successful exit are also maintained – why run the gauntlet with a C Corp.? All downside, no upside –best case, if stars align, will only get result LLC would have provided without risk.
Section 1045 of IRC
This provision allows for the rollover of a gain from the sale of stock of a QSBC to a subsequent investment in another QSBC. This is similar, in concept, to rolling over the gain on the sale of a personal residence to the next residence, as long as you pay as much or more for the next residence.
The problems with this provision are:
- One only has 60 days from the sale of the first QSBC to identify and invest in the next one, which often will be very difficult to accomplish without being “reckless” and doing little, if any, diligence.
- Because the mortality rate of startups is so high – generally 50% or above, there is a reasonable chance that one would roll over a gain into a new company that then goes out of business. If this occurs, then what you thought was a benefit, actually becomes a negative. The reason is that you are only receiving a 20% tax benefit for the loss – since you only avoided 20% tax by doing the rollover. Had you paid the 20% tax on the profitable sale, and then invested cash in a new LLC deal rather than a C Corp, when the new deal craters the LLC would have provided a 40% loss recovery – not 20% via the rollover. Thus, when you crunch the numbers, you are worse off in this scenario.
- Section 1045 is only a deferral mechanism; it does not permanently eliminate the tax.
- In order to qualify for the rollover, you must invest in another C Corp, not an LLC taxed as a partnership, which then raises the distinct chance of incurring 50% tax rather than 20% on the exit, which swamps the potential time value of money benefit of Section 1045.
- Thus, once again, the deck is heavily stacked against using this provision and moving from one C Corp to a subsequent C Corp.
Our nation’s tax laws are complex and difficult to learn and understand, just from a single party’s perspective. A sale of a company involves three parties – the buyer, the seller, and the Treasury/IRS, which makes an evaluation even more complicated. Large companies, investment funds, law and accounting firms, have poured over these topics for years, and identified certain relationships and structures which tend to legally minimize tax burdens and greatly increase returns.
Applying these same strategies in the Angel and smaller investment fund space offers a seemingly tremendous opportunity to materially improve investment returns, by merely changing the legal structure that houses the identical business. There may be no “totally free or painless lunches”, but this may be the next best thing.
Next Section: Handling Common Administrative Issues with LLC’s
Back to Summary Article and Index
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.