How a business is taxed depends in part on its structure, e.g., partnership or corporation, and its business activities. The most commonly used structures for a business entity are as follows:
- Sole Proprietorship: The simplest business form, as the business and the owner are considered to be inseparable. A sole proprietorship is subject to “pass-through” taxation, which means that the profits and losses go through the business and flow to the owner’s personal tax return;
- General Partnership: A partnership is a business owned and operated by two or more people for profit. It is also subject to “pass-through” taxation. Each partner is taxed on their individual share of the partnership’s profit;
- Limited Partnership: A limited partnership consists of general partners and at least one passive limited partner. For tax purposes, limited partnerships share “pass-through” taxation with general partnerships;
- Corporation: A corporation is a legal entity that is separate from its shareholder owners, which results in the protection of shareholders from personal liability for the corporation’s debts and liabilities. The standard C corporation does not have a “pass-through” taxation but rather incurs “double taxation.” After a C corporation deducts its expenses, it must pay income tax on its profits.
- Dividends are taxable to shareholders. Other corporate structures are available as well;
- Limited Liability Company (LLC): LLCs offer one-level “pass-through” taxation, as well as liability protection for business debts. LLCs can elect to be treated as a C Corporation. LLCs are not regulated as heavily as S Corporations.
Is There a Best Business Structure for a Startup?
Generally, a startup business expects to grow quickly. They believe they have something that they expect to be able to sell to lots of people in a short amount of time because the market for their product is sizable. Startups are most common in the tech industry for this reason.
Startups tend to be smaller and less structured than traditional small businesses. Additionally, they are most commonly innovative and able to adapt quickly to technological or market changes. Startups also tend to be more efficient and have less overhead, which allows them to be competitive in their pricing.
One of the defining characteristics would be that startups generally have more of a “team” feel. The employees could be close-knit, contributing to a culture of collaboration, sharing ideas, and working together for the benefit of the group.
Additionally, many startups emphasize providing a personalized experience for their customers. Because of their ability to personalize services and adapt to the unique needs of their customers, startups enjoy a degree of loyalty that many other businesses do not.
However, there are also disadvantages to startups, namely the level of risk. Many startups fail within the first year because getting a startup off the ground means working many hours, and the compensation might be low initially.
The cost of creating a startup may be high because of the cost of working to acquire customers and market share. The startup might not have the capital to conduct necessary market research and hire competent employees who share the same vision and dedication to the company. If this is the case, the startup is less likely to be successful.
Having fewer financial resources also means that the startup is especially vulnerable to competitors even as it starts gaining customers, as bigger businesses are likely to use their larger budgets to push the startup out of the market.
Consulting a lawyer for business startups can help the founders choose a structure that best suits the unique needs of their startup. In addition, it can help them navigate the law as it applies to the following topics:
- Deciding on the structure that the startup should have, whether a limited liability company (LLC), a general partnership, a limited liability partnership (LLP) or something else. The founders may well want to choose the structure that would protect their personal assets from liability for the debts of the business or the other members.
- On the other hand, the available tax breaks, discussed below, may compel a certain choice of structure;
- Tax implications and tax incentives for startups;
- Paperwork and financing agreements;
- Ensuring that intellectual property is protected;
- Negotiating real estate contracts; and
- Drafting employment contracts.
Are There Tax Breaks for Startups?
There are three tax breaks for investments in startups in the federal Internal Revenue Code (IRC). It is important to note that making use of the tax breaks would require the startup business to be formed as a domestic C corporation.
The first is in Section 1202 of the IRC. It allows as much as 100% tax-free gains for as much as $10 million in gains (or 10 times the cost basis, whichever is greater) for qualified stock that is held for more than 5 years.
The investment would only qualify if it meets the requirements of qualified small business stock (QSBS), which says that:
- The business is structured as a domestic C Corporation and not an LLC. It must not operate a hotel, farm, mining company, restaurant, or financial institution. It must also not be a business that is related to architecture, law, or engineering;
- A taxpayer investment must be in the form of common or preferred shares and not in the form of convertible notes of SAFE;
- The taxpayer must be the original purchaser of the investment who bought the shares directly from the issuing company. This means they were not bought on a secondary market;
- The business has never been in possession of gross assets that exceed $50 million in value. It may not have assets that exceed $50 million in value immediately after its initial offering of stock;
- The company meets certain active business requirements, with at least 80% of its assets for the active conduct of one or more qualified businesses;
- The QSBS must have been acquired after September 27, 2010.
A second tax break related to startups is found in Section 1045 of the IRC. It is referred to as the “QSBS Tax-Deferred Rollover.”
If a person holds a QSBS investment for over 6 months and less than 5 years, they are able to roll their gains over into another QSBS investment. By doing this, they would defer paying taxes on any gains. The rollover in the QSBS investment must take place within 60 days of liquidating the first QSBS investment.
A person could maintain the new QSBS investment for 5 years after adding the original QSBS holding period to the new holding period. If so, they may be able to make use of the Section 1202 tax-free exemption when selling the new QSBS.
The person must make a special election to claim 1045 treatment on their federal tax return in the year of the sale. Both the original investment and the rollover must be in QSBS. For this reason, both of the businesses in which a person invests must be C Corporations and not LLCs.
A third tax exemption is found in Section 1244 of the IRC and is referred to as “Small Business Corporation (SBC) Losses.” Startup investors who incur a loss on one of their investments may be able to make use of it. They may be able to write off qualifying losses as ordinary income, up to $50,000 on a return filed individually or $100,000 if filed jointly.
Since these losses are being written off as ordinary losses instead of capital losses, and since you can write off up to $50,000 a year instead of the $3,000 limit for capital losses, this can result in larger tax savings than you otherwise would get for public market stock losses.
A loss must meet several requirements to qualify as an SBC loss, as follows:
- The investment must consist of stock in a domestic C- or S-Corporation;
- The stock must have been purchased in exchange for cash or property only,
- The stock must have been purchased directly from the issuer and not in a secondary sale;
- The stock must have been issued as part of the first $1 million raised by the issuer;
- For the 5 years before loss, at least 50% of the company’s gross receipts must have come from an active trade and not from royalties, rents, interest, etc.;
- Even if the gross receipts test is passed, the stock must not be in an investment or a holding company.
Should I Get an Attorney to Help Me with My Startup Issues?
If you are planning a startup and want more information about how it should be structured and the tax implications, you want to consult a tax lawyer for further advice. LegalMatch.com can connect you to a lawyer who can also draft any contracts and agreements you may need and review all licensing and regulatory guidelines to ensure that you are in compliance.
It is a good idea to establish a relationship with a lawyer who would also be able to represent you in court, as needed, should any legal issues arise.
