Why Most Startups Incorporate as C Corporations
In our initial posts, we discussed formation considerations for startups and founders, including choice of entity considerations. In those posts, we assumed that the startup would opt for a state law corporation taxed as a C Corporation, as the vast majority of startups end up going this route. In this post, we dig deeper into why that is the case.
While there are a number of factors to consider when selecting the legal entity best suited for your startup, four considerations typically drive founders to opt for a C Corporation—(1) investor preference to invest in C Corporations over “flow through” entities like Partnerships (including LLCs taxed as Partnerships) and S Corporations; (2) the ability to issue preferred stock in a venture financing; (3) the relative ease of issuing incentive equity compensation to employees and other service providers; and (4) the availability of Qualified Small Business Stock (QSBS) treatment upon a sale of C Corporation stock.
Investor Preference: Tax Considerations
First, venture investors typically prefer to invest in C Corporations because a C Corporation is subject to tax at the entity level, meaning the entity’s profits and losses do not flow through to the corporation’s shareholders like they do in LLCs and S Corporations. Investors prefer not to receive K-1s from flow through entities, which are issued to owners of Partnerships and S Corporations to allow them to report on their individual tax returns their applicable share of the Partnership’s or S Corporation’s profit or loss for a tax year. A startup’s profits and losses do not impact an investor’s personal tax return when investing in a C Corporation.
Issuing Preferred Stock
Second, a C Corporation is nearly always required for venture investment given the near certainty that such investors will require preferred stock over common stock. Preferred stock comes with certain voting and/or economic rights not offered to holders of common stock, and investors typically require these additional rights as part of a venture investment. Issuing preferred stock is a seamless process in C Corporations, and there are generally accepted investment terms and form documents to assist in raising a preferred stock financing in a C Corporation.
While it is possible to do a venture investment in a Partnership, it is typically not as seamless a process as in a C Corporation. Conversely, one of the requirements of S Corporation status is that only a single class of stock can be issued, meaning that the creation and issuance of preferred stock would blow the S election and result in C Corporation tax treatment by default.
Incentive Equity Compensation
Another equally important consideration driving founders to C Corporations is the relative ease of issuing incentive equity compensation to the company’s employees and other service providers. Startups are often cash-strapped in the early days and cannot afford to pay salaries offered by more established companies. To bridge this gap and in an effort to attract top talent, the startup can issue incentive equity compensation to employees and other service providers, giving them upside if the company takes off. This equity compensation typically takes the form of a stock option, which gives the recipient the right to buy a share of stock at a pre-determined price (typically the fair market value of a share of stock on the date of issuance of the stock option) as the stock options vest over time (typically over a three to five year period from the date of issuance). The holder of the option is thus aligned with the founders to work hard and drive up the company’s value, as the stock option becomes more valuable to the option holder as the company appreciates.
Issuing equity compensation in a Partnership (typically an LLC) is absolutely possible, though typically that takes the form of a “profits interest”. I have found that profits interests don’t have the same incentivizing effect on recipients relative to stock options. Profits interests are not as widely used as stock options, and as such those who receive them are less likely to understand how they work or the upside they offer. While this shouldn’t preclude the use of profits interests, companies should be prepared to spend the time to ensure that the recipients understand how they work. Ultimately, the goal is to align the recipient’s interests to the interests of the founders and investors. Without an understanding of the upside tied to a profits interest (or any incentive equity compensation) the incentivizing effect is minimized.
QSBS Tax Treatment (Internal Revenue Code Section 1202)
One major consideration driving founders to C Corporations is the availability of QSBS treatment upon a sale of stock. At a high level, IRC 1202 allows holders of certain C Corporation stock to exclude from federal tax a substantial amount of gain (generally speaking, up to $10 million) from a sale of such stock. There are a number of requirements that must be satisfied for QSBS/1202 treatment to apply. A few of the notable requirements are:
The C Corporation must be a domestic (US) C Corporation;
The holder of the stock must acquire the stock (a) at original issuance (i.e. they cannot purchase it from another shareholder); and (b) in exchange for money or other property or as compensation for services;
The issuing C Corporation must be a “qualified small business,” meaning (a) the gross assets of the C Corporation do not exceed $50 million at or immediately after the issuance of QSBS stock; and (b) it must satisfy an “active business test,” meaning the C Corporation’s assets are used in the active conduct of one or more “qualified trades or businesses” (i.e. any business other than those specified by the IRS as not qualifying); and
The QSBS stock must be held for at least five years from the date of issuance. If this holding period is not satisfied at the time of sale, IRC 1045 allows for a tax-free rollover of the gain into other QSBS stock. This makes QSBS status especially important to venture investors, who often have an investment horizon of less than 5 years.
Aside from the above, there are other corporate actions (e.g., certain redemptions of the C Corporation’s stock before or after an issuance of stock that would otherwise qualify for 1202 treatment) that can eliminate QSBS treatment. The above is intended to be a very high level overview of the rules around QSBS/1202, and I highly recommend speaking to an attorney well versed in Section 1202 before assuming that QSBS applies, especially in light of the major tax benefits offered by QSBS treatment.
