Startup founders often have a lot of questions, but one of the most common is whether they should set up a C-Corporation for their new business.
Alternatives usually considered are the limited liability company (LLC) or an S-Corporation (a “pass through” version of a corporation). Very few founders consider establishing the traditional “partnership,” which is the third type of pass-through model.
There are a number of operational differences between LLCs and C-Corporations, but when looking at the raw “numbers,” founders often go the easier and “cheaper” solution of using an LLC.
A few years down the road, when things get good, they go through the “pain” of conversion from an LLC to a C-Corporation. This process has its own tax and corporate challenges. Sometimes they also “move” their legal entity from their home location to Delaware – a process called “reincorporation,” which is also a bit of a pain and takes some time.
The fundamental financial reason for using an LLC is that the US Tax Code had a pretty big penalty for using a C-Corporation: double taxation.
However, with the “Tax Cuts and Jobs Act” (the “New Tax Law”), Congress essentially took the tax “penalty” off the table.
Today, as the vote to approve the New Tax Law approaches, the fiscal situation seems a lot less stark.
The New Rules
Very few founders should now be driven by taxes to establish an LLC. The New Tax Law makes the C-Corporation penalty much smaller, and if you are building the next moonshot, you should consider setting up a C Corporation.
In other words, use an LLC if you intend to hold your business forever. You should also seek only the simplest sorts of investment and never give your employees real options/equity. Additionally, if you are a doctor, architect, engineer, financial consultant, real estate profession, or are in another profession in which you charge for your time, you’ll want to use an LLC.
If, on the other hand, you have any desire to raise funds, create different classes of stock, “exit,” give your employees equity or want to time when and how you pull money out of your new venture, you need to set up a C Corporation – and it should be started in Delaware.
The Current Tax Situation
Before the New Tax Law, a C Corporation was an “expensive” way to structure your business. C-Corporations gave a lot of protection and allowed great flexibility and planning – but double taxation hammered small business returns and often choked off growth.
In the following example the founder files “single,” and I exclude other smaller taxes such as the “Obamacare” tax penalty of 3% (and some other smaller excise taxes) and social security in order to keep the analysis simple.
The current corporate tax rate has several different brackets that ultimately lead to a 35% tax rate for the C-Corporation. The highest tax rate on qualifying dividends is 20%. Double taxation meant that first the Corporation paid tax on the net profits and then the owner paid tax on any dividends.
The means that if the C-Corporation makes $100,000 in profit, the Corporation will first pay $35,000 in corporate income tax, leaving $65,000 to be distributed to the owners. If the $65,000 is then distributed as a “dividend,” the tax on the $65,000 will be 20% or $13,000. $52,000 would finally be distributed to the owner of the Corporation and a punishing 48% tax rate applied.
If one uses an LLC, where the top tax rate on an individual is 39.6%, the tax on $100,000 of income is $39,600 and $61,400 would be distributed to the owners of the LLC. Still a high rate of taxation – but a good 10% lower than using a C-Corporation.
The New Tax Situation
Under the New Tax Law, on $100,000 of profit, the Corporation will now pay 21% tax, or $21,000, leaving $79,000 to be distributed to dividend, then $15,800 will be taxed and $63,200 will be distributed to the owners. This is an effective 37% tax rate – much lower than the previous 48% tax rate.
Unless the LLC uses significant capital or has wages (and can take advantage of the 20% profit “haircut”), the numbers look a lot closer. See the below table:
The choice between a basic LLC and a C-Corporation now is no longer tax driven to such a large extent. If, however, a business is going to hire employees or deploy significant capital (machinery for example), then there a founder should still go through a tax and business analysis.
Ultimately, the New Tax Law closes the “penalty gap” between C-Corporations and LLCs, so the choice of business entity should be driven to a greater extent by your Business Plan and less by tax considerations.
Under the New Tax Law, it’s worth taking a few extra minutes to talk through the ramifications of using a C-Corporation or an LLC.