The Tax Cuts and Jobs Act in 2017 (TCJA) enactment had many start-up business owners rethinking their legal and tax structure.
If you’ve decided to set up as a corporation versus a limited liability company, your next question is whether it is now more tax advantageous to be a C corporation or one of the three pass-through entity structures: sole proprietor LLC, partnership LLC or S corporation.
The reason for this resurgence: TCJA reduced the federal C corporate tax rate from a graduated rate topping out at 35 percent to a flat rate of 21 percent. This prompted many start-ups to question if they formed under the appropriate tax structure. They began to ask, "Should we switch from a pass-through to a C Corporation, or vice versa?"
The tax rate reduction has indeed made the effective rate for C corporation shareholders much closer to those who owned pass-through entities. TCJA, however, didn't change how dividends are taxed. Dividend payout is still taxed at the personal level.
Additionally, TCJA included up to a 20 percent deduction of qualified business income for certain business pass-throughs. If you plan to make dividend distributions from the business regularly, pass-throughs are still advantageous, especially if you take advantage of the new TJCA tax deduction.
But, of course, the decision isn't that simple.
Considerations beyond taxes
The biggest factor for selecting the C corporation structure is the significant tax benefit upon exit.
Under Section 1202 of the Internal Revenue Code (IRC), founders and investors can potentially exclude up to 100 percent of the federal capital gains tax when selling their stake in a start-up or qualified small business. Before TCJA, the exclusion ranged from 50 percent to 75 percent in prior years. There are a couple of limitations and qualifications.
First, the maximum exclusion is set at the greater of:
- $10 million reduced by any amount the taxpayer excluded from sales or exchanges of QSBS from the same issuer in prior years
- 10 times the aggregate adjusted basis of the QSBS issued by the corporation disposed of by the taxpayer during the taxable year, as measured on the original issue date
Next, the exclusion only applies to qualified small business stock (QSBS) held for more than five years and acquired at its original issuance in exchange for money, other non-stock property or as compensation for services.
The company must meet an aggregate gross assets test and meet active business requirements.
How to meet the QSBS exemption
To be considered a QSBS, the C corporation needs to meet three threshold requirements:
- The corporation's aggregate gross assets, including any predecessor corporation, did not exceed $50 million at any time before issuance.
- The aggregate gross assets of the corporation immediately after issuance did not exceed $50 million.
- The corporation agrees to submit reports to the Secretary and its shareholders as the Secretary may require.
Aggregate gross assets just means the amount of cash and property the corporation holds. It's important to note that it is ok for assets to exceed $50 million during the required 5-year holding period. The original stock issued at start-up and before it hit $50 million would qualify for the exclusion. Any stock issued after the original issuance would not be eligible as QSBS once the gross assets exceed $50 million.
There's still one more test. The C corporation must also satisfy the “active business” test for the stock to eligible for QSBS status. To pass, the corporation must pass both of two hallmarks:
- Must use at least 80 percent of its assets (as measured by fair market value) in the active conduct of a "qualified trade or business" (the "80 percent test")
- Cannot be a domestic international sales corporation (DISC) or former DISC, regulated investment company (RIC), real estate investment trust, real estate mortgage investment conduit, or cooperative
It may seem like a lot of hoops to jump through. But 100 percent exclusion on capital gains might be worth it.
How do you want to be paid — both now and later?
The TCJA seems to stack the deck in favor of C corporation, with a 21-percent corporate income tax rate and 100-percent gains exclusion. But then again, a 20-percent deduction of qualified business income for pass-through entities isn't bad either. Our advice: weigh the tax benefits while you are part of the company against those that might occur when you leave.
Still have questions?
TCJA is all a lot to process. If you still have questions, contact us to talk through the decision. Or learn more about how we serve start-ups on our web page.
Or learn from these resources:
What type of legal entity structure should I form?
SOC exam benefits for blockchain start-ups
How R&D tax credits can help start-ups