Angel Investing: Invest in C Corps, S Corps, or LLCs?
Posted by Pierre de la Fortune on April 15, 2015 @ 12:01 a.m.
Written by Joey Lo
Does the form of entities you invest in matters?
You bet it does. The differences in taxation and flexibility in ownership and capital structuring among them can be significant.
Does one structure trump over the others? Let’s do a head-on comparison. Company Structures
C Corporation (C Corp.). Owners of a C Corp are called “shareholders” or “stockholders.” Investors of a C Corp. are part owners of the company and are given stock certificates to evidence ownership.
A C Corp. is treated as a separate entity from its owners/shareholders in the legal standpoint. This separation shields shareholders from debt or obligations incurred by the company.
S Corporation (S Corp.). Like a C Corp., owners of an S Corp. are also called “shareholders” or “stockholders” and are given stocks to evidence ownership.
An S Corp. is also a separate entity from its shareholders, providing them limited liability protection from creditors.
The main difference between a C Corp. and an S Corp. is in the way income is taxed. We’ll expand the discussion of taxation in the next article.
Limited Liability Company (LLC). Owners of an LLC are called “members.” Instead of stocks, investors (as part owners of the LLC) receive “membership interest.”
The membership interest is usually expressed in percentages (e.g. a 10% membership interest) or units (e.g. 10 units), which generally correspond to percentage ownership, according to attorneys Jere Friedman and Jeffrey Bojar.
Unlike shareholders of a C Corp. and an S Corp., who receive stock certificates to evidence ownership, LLC members receive charter documents, i.e. the Articles of Organization and Operating Agreement.
An LLC also provides members limited liability protection from incurred debts. Ownership / Structuring Flexibility
C Corp. There’s high flexibility in who can hold equity or invest in a C Corp., and in structuring special rights (e.g. valuation, preferences, and protections) for various shareholders; that is, different shareholders can hold different rights.
S Corp. In comparison, an S Corp. lacks flexibility. The number and type of persons who can own equity in the company are restricted.
Specifically, there must be no more than 100 stockholders in an S Corp., and all of them must be (i) US citizens or residents, (ii) estates, (iii) eligible trusts, or (iv) certain tax-exempt entities, comment Greg Lynch and Melissa Turczyn, attorneys at Michael Best.
In addition, thanks to limitations imposed by tax laws, only 1 class of stock is allowed in S Corps. You see, experienced investors typically invest in preferred shares whereas founders and early employees hold common shares. This requires the company to issue 2 classes of stock. Therefore, the 1-class stock restriction has driven many investors away from investing in an S Corp.
LLC. LLCs have tremendous flexibility in who can be a member and in structuring the rights of various owners or members. This structure is appropriate for smaller companies with a limited number of members.
“An LLC is governed by the operating agreement, which can be modified any way the founders want to modify it,” Jeff Solomon, the head of audit at public accounting firm LKN+S, told ACEF.
For instance, they can say, we are going to allocate all the losses to you and profits to me. Or the agreement can say that I get all the cash, and you don’t get any.
In complicated investing deals, if certain investors need certain preferences, you can do better with an LLC because you can make that agreement do whatever you want.
I have seen [operating] agreements at hundreds of pages as well as simple ones.
Next, we’ll look into how company structures affect tax payments, filing, and reporting.
Tax Payments and Filing
C Corp. Profits and losses are captured at the company level.
If it generates profits, they’re taxed twice: first the company pays tax on its income, and then the stockholders report the income on their personal tax return, and pay tax at their individual tax rate, on any dividends or capital gains received.
This is called double taxation.
Even so, most early-stage companies operate at a loss so double taxation isn’t that big of an issue.
The losses a C Corp. generates at the early stage are also trapped at the company level. These losses are known as Net Operating Losses (NOL), which can be used to offset future income for the company for 20 years, ACEF explains. The offset will result in future tax savings.
C Corp. shareholders only pay tax on dividends or gains that are actually distributed to them by the company. And they don’t have to file separate state income tax returns in every state where the company earns income.
S Corp and LLC. Unlike C Corps, both S Corps and LLCs are “flow-through” entities in which income and losses bypass the company and flow through to shareholders and members, respectively.
Although S Corps are separate legal entities like C Corps, income and losses in S Corps are reported in a way that resembles partnerships.
If the company generates income, it isn’t taxed at the company level; it flows through to shareholders or members and is only taxed once at their individual tax rate.
This is called single taxation.
If it operates at a loss, which many startups do, the loss also passes through to shareholders or members, which “may effectively lower the [investor’s] net investment and raise their internal rate of return,” said Peter Rosenblum, senior partner at Foley Hoag.
However, note that - * Investors (S Corp. stockholders and LLC members) can’t deduct losses in excess of their investment amount. * Passive losses can only offset passive income. Put another way, passive losses can’t offset taxable non-passive income, which includes dividends, interests, and royalties.
Shareholders and members need to pay tax on their pro rata share of taxable income, even if the company hasn’t actually distributed any profits to them, attorneys Jere Friedman and Jeffrey Bojar enunciate.
Unlike stockholders in a C Corp., S Corp. shareholders and LLC members are required to file a separate state income tax return in each state the entity earns income.
Because of their “flow-through” ability, S Corp. stockholders and LLC members are liable for tax on their share of the company’s income. Hence, both S Corp and LLC entities must issue Schedule K1 to their shareholders and members, respectively. “This makes their individual tax reporting more complicated and slow,” ACEF comments.
Schedule K1 is a tax document used to report the shareholder or member’s share of the company’s income, deductions, and credits.
Not only is the administration effort unappealing to companies but it’s also a nuance to their shareholders or members. One prominent angel told Greg Lynch and Melissa Turczyn, attorneys at Michael Best, that “he refuses to invest in any more LLCs or S-Corps because he had 27 Schedule K-1s and was spending an inordinate amount of money on his personal tax returns.”
It’s worse for angel funds. ACEF clarifies:
“Having to deal with K1s can be a huge negative if you are an angel fund and you have invested in many LLCs,” [says John Huston, founder of Ohio TechAngels.] “I’ve lived this every year from both sides.
Angel funds are LLCs. Like all LLCs, we must provide K1s to our investors. But we can’t provide them until each and every one of our investee companies has submitted their K1s to us, which is often delayed.”
If even a single company is tardy with its K1, then the K1s going to the angel groups investors will be tardy, too.
“We can be held up by one little portfolio company,” says Huston. We can’t submit our K1s to our investors until we get all the K1s from our investments.
With a C Corp., you may leave on the table some interim tax benefits while a venture is throwing off losses, but could they possibly be large enough to overshadow all the hassle that the fund manager or angel group leader incurs dealing with many K1s each year? I doubt it.”
For many angel groups, the non-tax and administrative issues raised by LLCs trump the tax considerations. For more info please visit: http://myventurepad.com/joeylo/62487/angel-investing-invest-c-corps-s-corps-or-llcs?ref=node_other_posts_by &
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