By Richard D. Harroch and Grady Bolding
When forming and operating a startup, entrepreneurs face some critical tax issues. By paying attention to these issues, startups can position themselves to take advantage of some meaningful tax benefits and avoid tax problems. Here are 9 key tax issues to consider:
1. Forming the Company as a C Corp, an S Corp, or an LLC
The founders of a company must initially determine whether to organize the company as a limited liability company (LLC) or a corporation. If formed as a corporation, the company must also determine whether to file an election to have it taxed as an “S corporation” rather than a “C corporation.”
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their stockholders for tax purposes. Stockholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates (so called “flow-through taxation”). This allows S corporations to generally avoid double taxation on the corporate income.
To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable stockholders (i.e., individuals, certain trusts, and estates but not partnerships, corporations, or non-resident alien stockholders)
- Have no more than 100 stockholders
- Have only one class of stock
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)
In order to become an S corporation, the corporation must submit IRS Form 2553 Election by a Small Business Corporation (PDF) signed by all the stockholders. See the IRS Instructions for Form 2553 for required information and to determine where to file the form.
A C corporation under federal income tax laws is one that is taxed separately from its owners. Generally, all for-profit corporations are classified as C corporations, unless the company validly elects to become an S corporation. A C corporation does not have limits as to who could be the stockholders (as S corporations do). And C corporations may have different classes of stock (such as preferred stock and common stock), which is not allowed for S corporations. Venture capitalists will typically only invest in preferred stock in a C corporation.
An LLC is another entity that provides limited liability to its owners the way C and S corporations do, and an LLC also provides flow-through taxation to its owners.
So what type of entity should a founder form?
- If the company will be getting outside investors, it will most likely need to be a C corporation.
- If it’s a simple company with one or two individual owners, an S corporation makes sense.
- If the owners want greater flexibility for types of owners and wish to avoid the restrictions of S corporations, then an LLC or C corporation makes sense.
2. Qualified Small Business Stock
If the stock of a startup meets the requirements of “qualified small business stock” (QSBS), 100% of the gain on the sale of such stock held by a non-corporate taxpayer for more than five years may be excluded from income. In addition, gain on the sale of QSBS held for less than five years may qualify for a tax-free “rollover” treatment if the sale proceeds are reinvested in another QSBS within 60 days after the sale.