How Your Incorporation Decision Can Save Or Cost You Millions In Taxes

Understanding how taxes work for LLCs and C corporations can help you make the right choice when deciding what legal entity is right for your startup.

Many entrepreneurs believe that corporations are taxed more heavily than LLCs. This common wisdom might hold water for businesses that turn a profit early on, like restaurants or services businesses. However, when it comes to startups, founders who choose to use an LLC instead of corporation may lose out on millions in tax incentives in the US tax code that only apply to stock corporations. These tax benefits are known as Qualified Small Business Stock or QSBS incentives and the rules exempting QSBS gain from federal income tax have been part of federal tax law since 1993!

In this article, we cover how LLCs and C corporations are taxed and what the implications are for your personal taxes. Let's start off with the biggest difference that could end up costing or saving you millions of dollars.

Deep in the IRS tax code you'll find Section 1202, which describes Qualified Small Business Stock (QSBS) and the special tax treatment to which it is entitled.

Before getting into what QSBS is, let's get one thing out of the way: QSBS only applies to equity in a C Corporation and not the membership interests in an LLC.

In other words, two founders, who had the exact same ownership percentage, and whose companies sold for the same amount of money are going to pay different tax bills on the proceeds from the sale of ownership in a C Corporation versus an LLC.

In general, for proceeds of the sale of equity to receive QSBS treatment, the following conditions need to be met:

1. The equity must be in the form of stock in a C Corporation. This must be a domestic C Corporation, e.g. one registered in the United States.
2. The equity must have been acquired directly from the issuer or underwriter (e.g. not through a secondary market transaction, tender offer, or other indirect means) in exchange for money or other property (excluding other stock) or as compensation for services provided to the corporation.
3. The corporation issuing the stock must itself meet a set of qualifying criteria related to the type of business being operated, as well as how the business uses its assets. (Don't worry: most tech startups meet these criteria, so they shouldn't be a problem. For more about non-qualifying industries, see the Note at the bottom of this article.)
4. The would-be taxpayer has held the stock for 5 or more years prior to realizing gains via the sale or exchange of qualified small business stock. Typically, because of this 5 year holding period, only shareholders who acquire stock early in the life of a company end up making use of the QSBS exemption.

What does this get you? If you purchased that stock during certain periods in 2010, and any time afterward, you don't have to pay taxes on the first chunk of the profits and can exclude these gains from your federal income taxes. How big is the potential gain exclusion? $10 million, or 10 times the cost basis of the QSB stock, whichever is greater.

The latter scenario typically only applies to investors investing more than a million dollars into a company to acquire shares. For an investor that invests $2 million dollars into purchasing stock in a company meeting the QSBS exemption, they would be able to claim a gain exclusion of up to $20 million on their federal tax return!

One of the most important tests for whether stock qualifies for the QSBS exemption is the company's financing and capitalization history, specifically the gross assets on the company's books. In order to qualify and meet the restriction around $50 million in assets, the corporation's “aggregate gross assets” cannot have exceeded $50 million at any time prior to when the shares were issued, with the additional restriction that the corporation’s assets cannot exceed $50 million after taking into account any cash or property paid for the stock being vetted for QSBS eligibility. This additional restriction would only typically be a determining factor in QSBS exemption eligibility for early stage investors investing into well-capitalized startups.

One final note on eligibility. If a company does a stock repurchase or re-sells QSBS shares to a third party on a secondary exchange, this may jeopardize the startup’s ability to qualify for the QSBS exemption. For a shareholder’s shares to be considered QSBS, the stock corporation may not make any stock redemptions or purchases from the shareholder or anyone related to the shareholder within a four year period starting two years before the issuance of the QSBS shares and two years after the issuance. A stock redemption is when a corporation repurchases its shares from its shareholders.

Recall earlier how we mentioned that a founder of a C Corporation would have a much better financial outcome than the founder of an LLC if the proceeds from an equity sale qualified for QSBS treatment? Let's play out a couple of scenarios to illustrate that.

Meet our two startup founders: Natasha and Emmet. Natasha is the co-founder of a C Corporation, and Emmet is the co-founder of an LLC. Both businesses are in industries and use their capital in a way that would qualify for QSBS tax treatment, but recall that Emmet's LLC is not eligible.

Apart from the different types of legal entity, Natasha and Emmet share basically everything else in common:

• Both companies were founded after 2011. And—what a coincidence!—both companies were incorporated on the very same day.
• Natasha and Emmet make decent salaries and pay 20% on long-term capital gains, the highest tax bracket. (For the 2022 tax year, individuals making more than $459,750 in taxable income are taxed at 20% for long-term capital gains.)
• When they founded their companies, Natasha and Emmet each invested $100 in their companies to acquire their ownership stakes, and now each of their respective positions are valued at $20,000,000.

In other words, both Natasha and Emmet are each looking at a $19,999,900 gain if they sell or exchange their equity.

Remember: Assuming all the other criteria around industries and business models are met (see Note), the QSBS exemption is triggered as a function of time, and that five years is the magic number.

What happens to Natasha and Emmet when they sell their ownership stakes and realize those gains? Let's see what happens on 3 different timelines: selling after 11 months in business, selling after 3 years in business, and selling after 6 years in business.

Every state in the U.S. has its own separate tax code, and not all of them follow the federal tax code when it comes to QSBS. For example, New York follows QSBS, but California does not.

The calculations presented in the below scenarios are for federal tax liability only, and assume no other deductions or extenuating circumstances. The below scenarios are hypothetical and meant to illustrate the potential tax bills for two startup founders: one company is eligible for QSBS, the other company is not since it is registered as an LLC. Please do not construe the below as tax advice and consult with a tax advisor before any major liquidity event for your startup.

Profit from the sale or exchange of financial assets bought and sold within the same 12-month period is taxed as ordinary income.

If Natasha and Emmet each realize $19,999,900 from the sale of their ownership stakes after just 11 months in business, both would end up with the same tax bill, all things being equal and assuming no other tax protection strategies.

At an effective federal income tax rate of 36.8%, both Natasha and Emmet would be saddled with a $7.35 million federal income tax burden from this sale alone, plus whatever their state taxes are.

In the U.S., proceeds from the sale of assets held for one year or more are treated as long-term capital gains. For the highest income tax bracket (making over $459,750 in income), the rate is 20%.

After three years, Natasha and Emmet each realized $19,999,900 in gains from the sale of their ownership stakes in their respective businesses.

Natasha and Emmet will each have the same tax bill from the proceeds of this sale, in this case $3,999,980 in federal long-term capital gains. Each state has different capital gains rates, and Natasha and Emmet may have to pay more depending on which state they're from.

QSBS is triggered at the 5-year mark, so Natasha's sale of equity in her C Corporation qualifies for such treatment but Emmet's LLC does not.

Our friend Emmet is stuck paying the long-term capital gains rate of 20% on his $19,999,900 gain, incurring the same $3,999,980 tax bill as he did in the previous scenario. Let's not feel too bad for Emmet, though, since he still walks away with around $15.99 million.

But Natasha, ever a sharp cookie, made the decision years ago to incorporate as a C Corporation, and her equity now counts as Qualified Small Business Stock. What does her tax bill look like?

The QSBS exemption shields the first $10 million of Natasha's profit, which means she has long-term capital gains exposure on the remaining $9,999,900. In the 20% tax bracket, Natasha's tax bill would be just $1,999,980–half of Emmet's bill.

But wait, there are other ways for Natasha to further reduce her tax bill: If she'd transferred half her stake into a Roth IRA and held it there for the minimum holding period of 5 years, her retirement account would be shielded from up to another $10,000,000 in capital gains tax exposure. The same is true if Natasha would have acquired stock through a trust.

For entrepreneurs, the QSBS exclusion can be an important part of estate planning as it enables founders and their families to preserve the wealth they create in their startups tax-free, in compliance with the Internal Revenue Code (known as the IRC).

And even without the trust or the IRA, Natasha could have also eliminated her long-term capital gains exposure by reinvesting profits (beyond the usual $10,000,000 exemption) into another C Corporation that could qualify for QSBS treatment, so long as she reinvests those gains within a rollover period of 60 days. There are many reasons why successful founders and early employees at technology companies become angel investors, and tax planning is definitely one of them.

Note: when it comes to state tax, the law can be different from state to state. For example the QSBS exemption is recognized in states like New York, but not in California where many entrepreneurs start their companies. Some startup founders have chosen to move out of California and other high-tax states in order to reduce their tax burden as part of their overall wealth management strategy. The tax savings can be huge!

For founders and investors alike, the Qualified Small Business Stock exemption provides a useful tax planning tool for entrepreneurs who build lasting businesses.

With the ability to shield $10,000,000 in personal gains (plus more if shares are held in a Roth IRA, trust, or get reinvested) for owners of C Corporation stock, QSBS tax treatment is perhaps the most compelling reason to choose a C Corporation over an LLC when setting up a startup.

One of the main disadvantages of a C Corporation—the myth of "double taxation"—doesn't really apply to startups. Startups are characterized by long periods of unprofitability, so the corporate entity behind a startup is unlikely to be taxed for a long time.

There are other advantages to C Corporations beyond QSBS eligibility. The stock-based nature of equity ownership in C Corporations is more conducive to raising money from investors and giving employees skin in the game, for example. Authorizing and issuing shares to your co-founders, employees, and investors is straightforward. (With Capbase, it takes minutes.) On top of that, C corp stock is compatible with convertible notes and SAFEs—two standard fundraising tools that are critical for early stage startups.

If you haven’t registered your company yet, create a Delaware corporation right off the bat. Don’t waste time messing around with an LLC and then convert to a C corp later.

Why? Because, as soon as you get shares in your new company, the clock starts ticking on QSBS. You need to hold the shares for a minimum five-year holding period requirement to qualify for tax exemptions, and it's the QSBS exemption in particular that will save you the most money when you sell your startup years down the road. While the holding period is long, the tax break can be huge for startup founders and others who hold shares in early stage startups!

As mentioned above, proceeds from the sale of companies operating in certain industries are not eligible for QSBS treatment. If you are unsure of whether your company will be eligible, consult with a tax advisor who specializes in startup finance to see whether your startup will be able to take advantage of these tax benefits.

As specified in Sec. 1202(e)(3)

A “qualified trade or business” means any trade or business other than:

• any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,

• any banking, insurance, financing, leasing, investing, or similar business,
• any farming business (including the business of raising or harvesting trees),
• any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
• any business of operating a hotel, motel, restaurant, or similar business.

In other words, QSBS exemptions favor companies in manufacturing, technology, research and development, and software. Proceeds from the sale of shares in a company like Robinhood, which is a brokerage, are not eligible for QSBS exemption; however, proceeds from the sale of Uber or Lyft shares could be eligible for QSBS exemption, since both of those companies are in the software industry.

Corporations that are involved in buying shares of other companies or buying real estate may also be ineligible for a QSBS exemption due to restrictions for any companies where:

• More than 10% of the value of the company’s gross assets consists of property investments (e.g. not property used by the company to conduct its business or trade)
• More than 10% of the value of the company’s net assets consists of stock or securities of corporations (subsidiaries of the company do not count for purposes of this calculation)

Before taking investment positions in real estate or stock, a company will need to audit its balance sheet to avoid endangering the QSBS status of company stock by crossing these 10% limits.