The recently enacted Tax Cuts and Jobs Act of 2017 (TCJA) lowered the tax rate on C corporations from a high of 35 percent to a flat 21 percent. This drastic reduction in the corporate tax rate has brought new attention to a tax strategy— which we call the C Corp Startup Strategy—that high-growth startups can use to lower taxes if certain conditions are satisfied.
The C Corp Startup Strategy depends on several key assumptions that are not practical outside of the high-growth startup environment. For many founders, the theoretical tax benefits offered by the C Corp Startup Strategy cannot justify the risk of double taxation characteristic of C corporations. But for high-growth startups that must be organized as C corporations to meet investor requirements, the C Corp Startup Strategy can provide an excellent tax result for both founders and investors.
Analysis of the C Corp Startup Strategy
The C Corp Startup Strategy a tax-planning strategy designed to take advantage of the low 21-percent corporate income tax without subjecting the income to double taxation. For this strategy to work, the owners must have a way to cash out on their investment without having to pay tax. The strategy requires two components:
- The owners must have a reinvestment strategy instead of an earnings distribution strategy; and
- The equity must qualify as qualified small business stock under Internal Revenue Code 1202.
To understand how the C Corp Startup Strategy works, we must look at each component.
Most businesses are taxed as either C corporations or pass-through entities. C corporations pay a flat 21-percent tax on income, but the same income is taxed again when it is distributed to the owners. Pass-through entities avoid this double taxation. The income of pass-through entities is “passed through” to the owners and reported on their tax returns. Because the pass-through entity is not taxed separately from the owners, the only tax is the one paid by the owners.
Owners with an effective marginal tax rate that exceeds 21 percent may think that being taxed as a C corporation would save taxes. For example, when business income is earned, a pass-through entity owner with an effective marginal tax rate of 28 percent will pay 7 percent more in taxes than a similar owner of a C corporation taxed at a 21-percent tax rate.
But the “savings” offered by the lower corporate tax rate is often illusory. Because the income of C corporations is taxed twice—once when earned by the business and again when distributed to the owners—a C corporation shareholder has no way to get the income out of the corporation without paying additional taxes. If the C corporation pays dividends, the income is taxed twice: Once at the 21-percent corporate rate, then again at the 15-percent or 20-percent qualified dividend rate. In some circumstances, the 3.8 percent net-investment-income tax may also apply.
Dividends are not deductible to C corporations. If the corporation pays dividends to the owners, the tax on those dividends—when added to the 21 percent paid by the corporation—exceeds the tax on the income of a pass-through entity.
Example: A founder forms a C corporation. Because C corporations pay a 21-percent tax rate, the corporation will pay $21 for every $100 of income it earns. That leaves $79 available for distribution to the founder. When the corporation pays that $79 to the founder as a qualified dividend, the founder pays an additional tax of 15 percent ($11.85) on the dividend, leaving $67.15 in the founder’s pocket. Although the tax on the corporation was only 21 percent, the combined tax rate was effectively 32.85 percent.
This example is overly simplistic, but it illustrates how the double taxation that applies to C corporations may offer an initial saving but will ultimately result in higher taxes. The owners of a C corporation will eventually pay more in taxes than the owner of a pass-through entity.
Paying salaries to owners is also problematic. Unlike dividends, salary paid to an owner-employee is deductible by the corporation. Because the corporation receives a deduction, the corporation does not ultimately pay an entity-level tax on income that is paid out in salary. But all the income is taxed at the owner-employee’s marginal tax rate and are subject to employment taxes. An owner that receives a salary from the corporation is in no better position than an owner of a pass-through entity.
The only way to avoid double taxation is to reinvest income into the business and minimize distributions to owners. This reinvestment strategy provides the most benefit to owners that forego salary and dividends. If the owners receive a salary or taxable dividends, each dollar that the owners receive is taxable and, unless the owners are in a low tax bracket, will result in higher overall taxes than if the business was organized as a pass-through entity.
The reinvestment strategy also assumes that all profits are reinvested into actively growing the business. If the profits are invested in passive investments, the personal holding company tax or accumulated-earnings tax could apply. Either tax would erase any tax savings resulting from the 21-percent corporate tax rate.
Qualified Small Business Stock
Most founders expect to benefit economically from their business. Founders that reinvest all profits into growing the business have no way to cash out on their investment until the business is sold. For businesses that use the C Corp Startup Strategy, the private sale or public offering of the business is the payday for their efforts.
A sale of stock in a C corporation is ordinarily a taxable event. Owners that sell their stock in a taxable sale pay a second layer of tax, defeating the purpose of the C Corp Startup Strategy. For the C Corp Startup Strategy to work, the founders must sell their stock in a tax-free sale.
Internal Revenue Code § 1202 provides the tax-free treatment founders are seeking. As long as the business meets the requirements of Internal Revenue Code § 1202—which requires that the founders own the stock for at least five years—the founders can sell up to $10 million of (or ten times their investment in) the corporation’s stock as qualified small business stock (QSBS) without paying taxes.
If the owners of the C corporation sell their stock as QSBS—without having received other compensation from the corporation—the corporation’s income escapes double taxation. The corporation is taxed at a flat rate of 21 percent on all income earned. Because the owners do not receive distributions from the business, they pay no owner-level tax. The owners reap the economic reward of the business only when it is sold, but since it is sold in a tax-free transaction, there is no taxable gain on to the owners on sale.
Other Benefits of the C Corp Startup Strategy
In addition to QSBS qualification, there are several ancillary tax benefits to operating as a C corporation:
- No Alternative Minimum Tax. Under TCJA, C corporations no longer pay alternative minimum tax.
- Fringe Benefits. The U.S. tax laws limit the amount that owners of S corporations and partnerships can deduct for life insurance, medical expenses, childcare, education expenses, and retirement plans. C corporations do not have the same limitation. Most fringe benefits for employee-shareholders of C corporations are deductible.
- No Limitation of State and Local Tax Deduction. TCJA limited an individual’s deduction of state and local taxes to $10,000. C corporations do not have the same limitation and can deduct all state and local taxes.
- Tax-Free Reorganization. Unlike businesses taxed as partnerships, business taxed as corporations—whether C corporations or S corporations—can participate in tax-free reorganizations under the Internal Revenue Code.
- No Phantom Income Risk. With C corporations, there is no risk that the owners will be taxed on income that is not distributed to the owners (phantom income). Owners are only taxed when distributions are made. The lack of phantom income eliminates the need for special provisions in the organizational documents or formation of a blocker corporation to shield investors.
- Fewer Ownership Concerns. Unlike sales of pass-through entities, foreign and tax-exempt investors can more easily sell stock in C corporations without being subject to additional taxes.
- No Hot Asset Concerns. As long as the stock is held long enough, a sale of C corporation stock qualifies for preferential long-term capital gain rates. For businesses taxed as partnerships, the portion of the purchase price attributable to accounts receivable, inventory, and depreciation recapture (hot assets) are taxed at higher rates.
Although these benefits would probably not justify double taxation in other circumstances, they are a bonus for businesses using the C Corp Startup Strategy.
Six Key Assumptions of the C Corp Startup Strategy
If properly executed, the C Corp Startup Strategy can save taxes. But the strategy depends on six essential assumptions:
- The stock must qualify as QSBS
- The owners must hold the stock for five years and then sell it
- The business must reinvest all income into growing the business
- The owners must not receive too much salary or dividends
- The sale must be structured as a stock sale
- The buyer must not discount the purchase price
These assumptions can be difficult to predict in advance, and even more difficult to maintain for five- years.
The Stock Must Qualify as QSBS
The C Corp Startup Strategy depends on the owner’s ability to cash out by selling the stock in a tax-free sale. The following requirements must be satisfied for the stock to qualify as QSBS:
- The corporation must be a C corporation in the U.S. It cannot be an S corporation or foreign corporation.
- The corporation’s assets must be $50 million or less before and after the stock’s issuance. If the corporation has raised more than $50 million of financing, for example, its stock is not QSBS.
- The corporation must be an active business (not a holding company) at all times that the stock is held.
- The corporation must be in a business other than one involving personal services; banking, insurance, financing, leasing, or investing; farming; mining; or operating a hotel, motel, or restaurant.
- Both the corporation and the shareholder must consent to provide certain documentation for the stock.
- The stock must be acquired in exchange for money or property or as pay for services provided to the corporation.
These requirements are explained in more detail in our discussion on QSBS. If these requirements are not satisfied, the owners will be taxed when they sell the business. The additional tax on the sale of the business will eliminate the tax savings from the C Corp Startup Strategy.
The Owners Must Hold the Stock for Five Years and Then Sell It
For the stock sale to escape taxation, the owners must hold the stock for at least five years before selling it. This five-year holding period requires owners to remain in the C Corp Startup Strategy model for five years. If the owners decide to make distributions to themselves or to keep the stock indefinitely, the C Corp Startup Strategy’s benefits are lost.
The C Corp Startup Strategy also assumes that the owners will sell their stock shortly after the five-year holding period ends. To qualify for tax-free sale, the stock in the entity must qualify as QSBS for the entire time the owners hold the stock. The longer the business operates after the five-year window closes, the greater the risk that the stock will no longer qualify as QSBS. If a sale of the business is not reasonably certain to occur shortly after the five-year holding period ends, there is a real risk that the tax savings will be lost.
The Business Must Reinvest All Income into Growing the Business
The C Corp Startup Strategy assumes that the business will need to reinvest earnings to accelerate growth. Because distributing revenue to the owners defeats the purpose of the strategy, any surplus funds must be reinvested into growing the business.
The Internal Revenue Code penalizes C corporations for allowing earnings to grow inside the business without distribution. C corporations that hold on to earnings instead of distributing to these owners may be subject to accumulated-earnings tax or personal holding company tax. Because either tax would limit the tax savings in the C Corp Startup Strategy, it is important to evaluate whether the business can successfully reinvest its after-tax proceeds into growing the business.
The Owners Must Not Receive Significant Salary or Dividends
The C Corp Startup Strategy assumes that most owners will not need the company to distribute earnings. Receiving salary or dividends eliminates potential tax savings.
- If the corporation pays dividends to the owners, the owners pay a second layer of tax on the dividends that, when combined with the 21-percent rate paid by the C Corp Startup, is almost always higher than the rate they would have paid as an owner of a pass-through business.
- If the corporation pays a salary, the owner pays tax at ordinary income tax rates and must also pay employment tax.
Many startup founders do not have the independent resources to grow a business for five years without receiving income from the business. This creates a possibility—perhaps a likelihood—that the owners will want or need to withdraw profits once the business grows. If the business is profitable and the owners receive distributions, the tax savings of the C Corp Startup Strategy is lost on each dollar distributed to the owners. But even though the owners may not save as much taxes as would be theoretically possible, the strategy may still result in overall tax savings if the owners that receive dividends or salary are minority shareholders. In other words, the tax savings to the majority of the shareholders may be enough to offset the double taxation on distributions to a few minority shareholders.
There are also ways to mitigate this result. For example, the owners could loan money to the company at the time of capitalization and receive it back from the corporation as loan payments. As long as the loans are structured in a way that passes the IRS’s rules for distinguishing debt from equity, the corporation may repay the loans without triggering a second layer of taxes. But this technique requires special planning and is somewhat limited.
The Owners Must Sell the Stock in a Stock Sale
To take advantage of the QSBS exclusion, the transaction must be structured as a stock sale. In addition to meeting the QSBS requirements, the shareholders must also find a buyer that is willing to structure the sale as a stock sale instead of an asset sale.
If the corporation goes public with an IPO, there is no problem. But buyers that purchase in private sales may be pickier. Most buyers prefer to buy assets instead of stock. Structuring the sale as an asset sale provides the buyer with a market-value basis in all assets being acquired, to amortize goodwill, and to choose which liabilities the buyer will assume as part of the transaction. Well-advised buyers may attempt to structure a private business acquisition as an asset sale
The Buyer Must Not Substantially Discount the Purchase Price
As stated above, many buyers prefer to acquire a business as an asset sale. If the buyer is unable to do so, the buyer may seek to discount the purchase price to reflect the lost basis increase and amortization opportunities, as well as the fact that the buyer is acquiring all liabilities (including unknown liabilities) of the business. A reduction in the purchase price could eliminate some or all of the C Corp Startup Strategy’s tax savings.
There is a great deal of risk to the C Corp Startup Strategy due to the assumptions on which it is based. If income is taxable to the owners, the owners will pay more tax on that income than they would if they formed an LLC or other pass-through entity. But most startups that use the C Corp Startup Strategy are high-growth technology startups seeking investor funding. Since these startups must be organized as C corporations anyway (to meet investor requirements), there is no downside to the C Corp Startup Strategy.