Tax Hacks for Tech Founders: How to Leverage C Corporation Status for Maximum Savings
As a tech founder, you have to juggle competing priorities including product development, design, intellectual property, finances, personnel, and more. However, one area that is often overlooked is tax planning. While this may not be the most exciting topic, it can make an enormous difference in your total investment return. In this article, we will explore how tech founders can leverage C corporation status to maximize their tax savings.
What is a C Corporation?
Before we dive into the details, it’s important to understand what a C corporation is. A C corporation is a corporation formed under state law (often Delaware) which has elected to be taxed under Subchapter C of the Internal Revenue Code. (By contrast, an S corporation is a corporation that has elected to be taxed under Subchapter S of the Internal Revenue Code.) A C corporation is treated as a business structure that is separate from its owners for tax purposes. This means that the corporation pays tax on its own income. The owners (i.e., shareholders) do not pay tax on the corporation’s income unless the corporation makes distributions to them. But if the corporation makes any distributions, the owners must pay their own tax on the distributions—sometimes referred to as “double taxation.”
The C corporation tax structure, with its inherent “double taxation,” can be burdensome for a stable, highly-profitable business you plan to operate for many years. But what if you plan to set up a high-growth company and reinvest most of the revenue while you position it for acquisition? In other words, a tech startup? In that case, a C corporation may be just the ticket.
Benefits of C Corporation Status
There are several benefits to choosing C corporation status for your tech business.
Raising Capital. One of the main benefits to choosing C corporation status is the ability to raise capital through the sale of stock, including preferred stock. This can be especially important for startups that need to raise significant amounts of capital to fund their growth. While an S corporation can also sell stock, it is limited to 100 shareholders and may only sell a single class of stock—in other words, no preferred stock.
Reinvesting Revenue in the Business. Currently, the federal income tax rate for a C corporation is only 21%. If the company is cash positive, this means that it can reinvest 79% of its revenue into product development. (The second layer of “double taxation” only kicks in if the company distributes money to its shareholders, not if it simply reinvests the revenue in the business itself.) By contrast, the federal income tax rate for an S corporation is equal to its owners’ personal income tax rates, which can easily be higher than 21%. The income taxes on S corporation earnings must be paid even if the company reinvests all of its earnings rather than distributing any to the owners.
Leveraging Qualified Small Business Stock (QSBS). Qualified Small Business Stock (QSBS) is a an incredibly powerful tax incentive that can seem tailor-made for tech startups and their founders. If you hold your shares for at least five years, you can exclude up to 100% of the capital gains from the sale of the stock. That’s right—up to 100%. And to the extent you realize capital gains that you cannot exclude, you may defer tax by if you reinvest the proceeds into another QSBS company within 60 days.
To qualify for QSBS, you and your tech startup must meet the following criteria:
The company must be a C corporation.
The company must have less than $50 million in assets at the time the shares are issued.
The company must use at least 80% of its assets in the active conduct of one or more qualified businesses.
The company must have issued your shares of stock to you after August 10, 1993.
You must hold the stock for at least five years.
The company must have issued the shares directly to you in exchange for money, property, or services. Shares that you acquire from someone else will not qualify for QSBS treatment.
Crucially, you must sell your shares of stock to realize the full tax benefits of QSBS. When the time comes for the company to be acquired, the purchaser is likely to prefer to purchase the assets of the company from the company itself. If this takes place, the company will pay tax on the proceeds of the sale—the benefits of QSBS only apply to the sale of shares, not the sale of assets. To realize the benefits of QSBS, you must persuade the buyer to purchase your shares—i.e., through an acquisition structured as a stock sale. This may involve sweetening the deal by sharing part of the tax savings with the buyer through a modest reduction in the purchase price.
This article highlights the potential tax benefits of choosing C corporation status for tech startups. Of course, C corporation status is not the most tax-efficient structure for every business. Be sure to seek qualified legal and tax advice before setting up your business.
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