By Steven Keeler
The legal and tax lingo for different business entity types can be confusing. A state law corporation can either be taxed as a “C” corporation or, if it meets certain requirements, elect to be taxed as an “S” corporation. A state law limited liability company or “LLC” with multiple owners can be taxed as a partnership or elect to be taxed as a “C” or, if it meets the same requirements, an “S” corporation. Companies taxed as “C” corporations and their owners pay two levels of tax, first at the company level on its profits, and then at the shareholder level on any dividends paid to the shareholders. Companies taxed as “S” corporations “flow” their profits through to their shareholders, who pay taxes on their proportionate shares. Companies taxed as partnerships, such as LLCs with multiple owners, also “flow” their profits through to their shareholders, although the tax rules applicable to S corporations and partnerships are quite different.
Most private companies have become accustomed to operating and reporting company and owner taxes based on their original entity form. However, when a company is planning to raise venture capital or growth private equity, or to sell its business, assets or equity in a buyout transaction, the tax implications of the transaction may require that the company change its current entity structure.
Companies Raising Venture Capital or Growth Private Equity
Most startup or emerging growth companies that raise venture capital are formed as C corporations due to their relative familiarity to investors, tax compliance simplicity and the prohibitive requirements for S corporations. For example, S corporations can only have one class of (or just “common”) stock and certain limited types of shareholders, and this does not typically allow for “preferred” stock or venture capital fund investors. And many venture investors prefer investing in C corporations to avoid certain tax impacts that arise from LLCs. That said, we have worked with many LLCs that successfully raised venture capital from angel and fund investors, primarily due to the company’s desire to obtain the tax flexibility of a partnership and avoid the double taxation incurred by a C corporation. We have also worked with many companies that converted their LLCs to C corporations prior to a venture capital funding. Family office and private equity investors are often more comfortable investing in LLCs than are institutional venture capital investors. No one size fits all, and the ultimate choice will be driven by both the company’s and investors objectives
Many corporations and some LLCs start out as electing S corporations to achieve flow-through taxation of profits and losses and to free up company profits from employment and self-employment taxes. But when it comes time to accept venture capital from an angel or fund group which is a partnership or LLC, the S corporation status has to change. The company could choose to become a C corporation. But, in our experience, it may be significantly more advantageous for the Company to “drop” the business down into an LLC and raise the capital through that LLC. Or even better, the company can do an “F reorganization” by forming a new S corporation above the company, having the company elect to be a “QSUB” and then converting the company to an LLC. By doing this, the founders and other owners continue to hold their equity through a “flow-through” entity (the news S corporation) and can close the venture capital or private equity financing through an LLC.
Companies Planning for a Sale
It is often said that buyers prefer to buy assets over buying corporate stock or LLC interests, units or shares. This is thought to provide the buyer with more successor liability protection and a better after-tax purchase price, because the buyer can increase the tax basis in the purchased assets and write off the company’s goodwill over a 15-year period after the acquisition. From the seller’s perspective, selling the assets of a C corporation can be prohibitively tax-expensive due to the double taxation imposed on C corporations. S corporations and LLCs can sell assets with less of a tax burden. But it is easier to structure a sale as a stock or equity sale than an asset sale. This is often due to the fact that, in a stock or equity sale, customer and other contracts, permits, intellectual property, licenses and other assets and rights do not have to be assigned to a buyer entity with some third party’s consent.
Fortunately, the tax laws permit buyers to acquire the stock of an S corporation or the equity of an LLC and still be treated as if they purchased the assets of the business. However, if the current owners desire or are expected to “roll over” some of their stock or equity into a new buyer holding company or entity (which is extremely common in private equity buyout transactions), an S corporation stock purchase will not allow that roll over to be tax-deferred. To solve this problem for an S corporation, the F reorganization transaction structure discussed above can work. And for an LLC, a tax-deferred owner equity roll over can be structured in any number of ways.
C corporation sales are a much tougher nut to crack. The selling shareholders will want to sell stock at one level of capital gain, and the buyer will want the benefits of an asset purchase described above. Converting a C corporation into an S corporation may have significant adverse tax consequences and usually won’t work, at least in close proximity to a sale. And dropping the business into a subsidiary of the C corporation prior to the sale will not allow the owners to get their cash and any roll over equity out of the C corporation double tax regime. If a buyer is unwilling to buy the stock of a C corporation, the company will need to do substantial planning to address the tax implications of an asset sale.
Take Aways
Most (but not all) venture-backed companies will likely continue to operate as C corporations given that this is the “preferred” form of entity from the perspective of investors and the company’s most likely exit will be via a stock sale to a larger company or an IPO. Fortunately, most of the family-owned, closely-held and private companies with which we have worked on growth equity capital raises or sales are structured as S corporations or LLCs, making the above planning techniques possible to achieve a “win-win” for the company, its owners and the investors or buyer. Forming a business as or converting a business to a C corporation is a step that cannot be easily reversed. Operating as an S corporation provides the next best planning flexibility. And, certainly, operating as or restructuring a business to include an LLC will, in our experience, almost always provide more planning alternatives in getting a financing or sale done on a tax-efficient basis for both the sellers and the investor or buyer.
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