Tax Considerations for Startups
- Double tax: Corporations are subject to tax on income and gains; shareholders are taxed on distributions.
- No viable tax-free exit strategy: Gain is recognized on liquidating distributions, so generally there is no tax-free way to get assets out of a C corporation. (There are some exceptions for parent corporations of liquidating subsidiaries.)
- Net operating loss (NOL) carry over: Can carry over losses in excess of income to reduce income (and therefore tax) in the two preceding taxable years and the 20 taxable years following the taxable year of loss. But use of NOLs is limited after certain changes in ownership.
- Debt financing: Can deduct interest payments, subject to certain limitations. But the IRS may attempt to re-characterize this debt as equity, thus causing deductible interest to be re-classified as a non-deductible dividend.
- Limited liability: Shareholders of corporations generally enjoy limited liability.
- “Flow-through” tax treatment: Members, not the entity itself, are subject to tax, so only one level of tax imposed.
- Flexibility: Allows for more flexibility in how allocations and distributions can be apportioned among owners.
- Complexity: Overlapping layers of anti-tax shelter statutes and regulations make LLC operating agreements very dense reading.
- Limited liability: Members enjoy limited liability.
- Shareholder limitations: Limited to 100 shareholders (natural persons and certain trusts) and only one class of stock. Shareholders cannot be non-resident aliens.
- Election required within specified time: all shareholders must consent.
- Flow-through tax treatment: Treated like LLCs – no tax at the corporation level, and corporation’s income, credits, gains and losses flow through to shareholders.
- Shareholder’s “flow-through” loss deductions: Shareholder loss deductions are limited to the aggregate tax basis of (i) the shareholder’s S Corp. stock and (ii) the debt of the S Corp. to shareholder.
- Borrowing: Stock basis is not increased by corporate borrowing, even if the shareholder guarantees debt; to increase basis and take losses, shareholder must borrow directly and contribute cash (or other property).
- Property distributions: If the S Corp. has earnings and profits from when it was a C Corp., property distributions will generate gain recognition.
- No special allocations: All income and loss is shared in proportion to stock ownership.
- Venture capital termination: Venture capital investment usually terminates S Corp. status because venture capital preferred stock violates rules against multiple classes of stock and VCs are disqualified shareholders.
Most taxpayers use the calendar year, but a taxable year other than the calendar year may be desirable depending on the taxpayer’s business cycle. There are different restrictions in place for each type of entity.
Method of Accounting
The entity must adopt a method of accounting which accurately reflects income. There are several methods available to the taxpayer.
- General rule: Exchange of old property for new property (e.g., a patent is contributed in exchange for stock in the newly formed entity (Newco)) is taxable.
- Amount of income (loss): The difference between the tax basis of the property and FMV of Newco stock received.
- Character of income (loss): Treated as ordinary or capital – short or long-term – depending on the character and holding period of the property surrendered.
- Incorporation transfers: Corporate founders (and other contributors) recognize no gain or loss when they transfer property to Newco in exchange for its stock if (i) founders receive only Newco stock; (ii) anything received in addition to stock is taxed as “boot” and gain may be recognized to the extent of boot received; and (iii) founders, immediately after transfer, are members of a group “in control” of Newco, which is defined as 80% of the combined voting power of all classes of stock entitled to vote and 80% of each nonvoting class. If these requirements are met, then the transfer of property results in non-recognition treatment.
Cheap Stock Issues
- Lowest risk for founders of income recognition is receipt of stock for services before any outside investors are in the wings.
- Common stock is generally valued at a discount from preferred stock; proper amount of discount is open to question, and third-party 409A valuations are generally advised after any preferred stock financing.
- Lower value means receipt (or vesting) of stock results in less risk of income recognition.
This outline is intended as a general overview of issues and considerations most relevant to typical startups. It is not intended to be a comprehensive discussion of all possible issues, considerations or concerns that would apply to any entity. Each entrepreneur should seek advice from their own tax advisor regarding their particular circumstances and the tax issues that might be most applicable to those circumstances.