C Corps v. S Corps

by Joe Wallin on June 9, 2013 in Business Entities with No comments

Suppose you’ve decided that you want to form your new business as a corporation (not an LLC), and you are trying to figure out if it should be an S Corp or a C Corp.  How do you decide?  Flip a coin?  Arm wrestle your co-founder?  Rely upon your lawyers or CPAs advice?  The following is a high level summary of some of the more important federal income tax and non-tax considerations involved in choosing between doing business as an entity taxed for federal income tax purposes as:

  • a C corporation (C Corp) vs.
  • an S corporation (S Corp); and

I generally don’t recommend a coin toss as the method of deciding.  Hopefully, the pros and cons listed below will help you.

C CORPORATION ADVANTAGES/S CORPORATION DISADVANTAGES

  • Traditional Venture Capital Investments Can Be Made – C corporations can issue convertible preferred stock, the typical vehicle for a venture capital and angel investment. S corporations may have a single class of stock only and therefore cannot issue preferred stock.
  • Retention of Earnings/Reinvestment of Capital – Because a C corporation’s income does not flow or pass-through to its shareholders, C corporations are not subject to pressure from their shareholders to distribute cash to cover their shareholders’ share of the taxes payable on account of taxable income that passes through to them. An S corporation’s pass-through taxation may make conservation and reinvestment of operating capital difficult because S corporations typically must distribute cash to enable shareholders to pay the taxes on their pro rata portion of the S corporation’s income (S corporation shareholders are taxed on the income of the corporation regardless of whether any cash is distributed to them).
  • No Single Class of Stock Restriction – S corporations can only have one economic class of stock; thus, S corporations cannot issue preferred stock. This restriction can arise unexpectedly, and must be considered whenever issuing equity, including stock options or warrants.  (S corporations can, by the way, issue voting and non-voting stock, as long as the stock is economically the same class.)
  • Flexibility of Ownership – C corporations are not limited with respect to ownership participation. There is no limit on the type or number of shareholders a C corporation may have. S corporations, in contrast, can only have 100 shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders (all shareholders must be U.S. residents or citizens).
  • Eligibility for Qualified Small Business Stock Benefits – C corporations can issue “qualified small business stock.” S corporations cannot issue qualified small business stock, thus S corporation owners are ineligible for qualified small business stock benefits, such as the 50% gain exclusion for gain on the sale of qualified stock held for more than five (5) years (for an effective capital gains rate of 14%) and the ability to roll over gain on the sale of qualified stock into other qualified stock.  Currently, for C corporations acquired before the end of 2013, this exclusion is 100% (subject to a generous cap).
  • More Certainty in Tax Status – A C corporation’s tax status is more certain than an S corporation’s; e.g., a C corporation does not have to file an election to obtain its tax status. S corporations must meet certain criteria to elect S corporation status; must elect S corporation status; and then not “bust” that status by violating one of the eligibility criteria.
  • Avoidance of Shareholder State Income Tax Problems – Shareholders of an S corporation may be subject to income taxes in states in which the S corporation does business.

S CORPORATION ADVANTAGES/C CORPORATION DISADVANTAGES

  • Single Level of Tax – S corporations are pass-through entities: their income is subject to only one level of tax at the shareholder level.  A C corporation’s income is  taxable at the corporate level and  distributions of earnings and profits to shareholders (i.e., dividends) that have already been taxed at the C corporation level are also taxable to the shareholders (i.e., the dividends are effectively taxed twice).  This rule is also generally applicable on liquidation of the entity.
  • Pass-Through of Losses – Generally losses, deductions, credits and other tax benefit items pass-through to a S corporation’s shareholders and may offset other income on their individual tax returns. These returns are subject to passive activity loss limitation rules, at risk limitation rules, basis limitation rules, and other applicable limitations.  A C corporation’s losses do not pass through to its shareholders.

 

Taxation of Social Purpose Corporations

by Joe Wallin on June 8, 2013 in Uncategorized with 2 Comments

Question:

I received the following question from a CPA friend the other day:

“I have a client that recently formed a Washington social purpose corporation. Do you have a sense of how SPCs are characterized for federal income tax purposes?”

Answer:

For tax purposes, Washington social purpose corporations are just a type of Washington for profit corporation, formed under the Washington Business Corporation Act, RCW 23B. There is no difference in federal or state tax treatment between an SPC and a regular for-profit corporation.

Accordingly, for federal tax purposes, SPCs are generally treated as ordinary C corporations, which are subject to corporate income tax. If they have only one class of stock and fewer than 100 shareholders, and otherwise qualify, they may elect to be classified as S corporations, which pass gross income, deductions, and losses through to shareholders.

SPCs, like other corporations, can’t be classified as partnerships. Similarly, because SPCs may distribute earnings to shareholders and use assets for shareholders’ benefit, they can’t generally qualify for tax-exempt status (such as Section 501(c)(3) or 501(c)(4) status).

For Washington State tax purposes, SPCs are taxed just like any other type of business entity. They are subject to the business and occupation tax, regardless of whether they are considered C corporations or S corporations for federal tax purposes; Washington does not recognize pass-through companies. They are also liable for sales tax on both sales and purchases, as well as property taxes, in the same manner as other Washington businesses.

Venture Capital Fund

by Joe Wallin on June 5, 2013 in Federal Law & Regulation with No comments

Flowchart for Exemption Under the Investment Advisers Act of 1940

By Joe Wallin and Asher Bearman

This article is appearing simultaneously on The Venture Alley and on Startup Law Blog. 

The below flowchart may be helpful to you in answering the question whether you qualify for the exemption for “venture capital funds” under Section 203(l) of the Investment Adviser’s Act of 1940 ( the “Advisers Act”), pursuant to the final rules promulgated by the SEC.1  In all cases you should consult with an attorney.  For more detailed information regarding the federal exemption, check here.  Note that the Washington State Department of Financial Institutions (DFI) has proposed rules that are going to require many fund managers to register with the State as investment advisors.  We plan to prepare a separate flowchart to help you understand those rules once they are finalized.
Venture Capital Fund

(i) http://www.theventurealley.com/vc-and-pe-funds/private-fund-adviser-exemption-150m-from-registration-under-the-advisers-act-final-dodd-frank-act-ru/

(ii) http://www.theventurealley.com/vc-and-pe-funds/reporting-requirements-for-funds-exempted-from-investment-advisers-act/

(iii) http://www.theventurealley.com/vc-and-pe-funds/washington-state-to-regulate-fund-managers/

1 Here is the full text of Section 203(l):  “EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.—No investment adviser that acts as an investment adviser solely to 1 or more venture capital funds shall be subject to the registration requirements of this title with respect to the provision of investment advice relating to a venture capital fund. Not later than 1 year after the date of enactment of this subsection, the Commission shall issue final rules to define the term ‘‘venture capital fund’’ for purposes of this subsection. The Commission shall require such advisers to maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.”

2 “Investment adviser” means, generally, any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.

3 “Qualifying investments” means (i) an “equity security” issued by a “qualifying portfolio company” that has been acquired directly by the private fund from the “qualifying portfolio company;” (ii) any equity security issued by the qualifying portfolio company in exchange for an equity security issued by the qualifying portfolio company described in section (i) above; or (iii) any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, as defined in section 2(a)(24) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(24)), or a predecessor, and is acquired by the private fund in exchange for an equity security described in sections (i) or (ii) above.

4 “Qualifying portfolio company” means any company that: (i) at the time of any investment by the private fund, is not reporting or foreign traded and does not control, is not controlled by or under common control with another company, directly or indirectly, that is reporting or foreign traded; (ii) does not borrow or issue debt obligations in connection with the private fund’s investment in such company and distribute to the private fund the proceeds of such borrowing or issuance in exchange for the private fund’s investment; and (iii) is not an investment company, a private fund, an issuer that would be an investment company but for the exemption provided by Section 270.3a-7, or a commodity pool.

5 “Equity security” means any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the Commission shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security.

6 An exempt reporting adviser is an adviser that has to make public filing of certain information, despite being exempt from registration.  For example, here is the exempt reporting adviser Form ADV for Union Square Ventures.

 

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