Why a Startup Should Never Start as a C-Corporation
Let me preface this by saying that I have been through the ringer. In the last few years I have created and dissolved a Limited Partnership (LP), a couple Limited Liability Companies (LLC), and a couple of C-Corporations, both of which I had to switch to S-Corporations. Furthermore, I personally did the taxes for all of these entities.
Along the way I learned some important information that I’d like to pass on to you to either save you time or money or both. Let’s begin with definitions and the processes with which these different types of companies are structured. The way a company is structured dictates among other things how its taxes are paid. Here is a quick overview —
Sole Proprietorships and LLC’s — These are the easiest types of companies to form and maintain. The money the company makes or loses passes through the company into the hands of its owners and investors. The entities themselves file their numbers with the IRS but never actually pay any taxes.
Limited Partnerships work pretty much the same way as far as taxes are concerned. The difference between an LP and LLC has more to do with structure and who controls the company. In LP’s the general partner is liable, and has control over the day to day operations of the company regardless of the amount of equity it holds (sometimes only 1%). Nonetheless, the taxes are still passed through the company to the partners, who can be people or other companies.
Corporations are different in that they issue company stock to the owners. This allows for easier transfer of ownership and thus makes it easier to get investments. In fact, most investors will demand the company be a corporation before investing.
There are 2 types of corporations, S and C. A C-Corporation is the traditional model, and it pays it’s own income tax. The money the owners and investors gain or lose in a C-Corp is considered capital gains and losses.
An S-Corp on the other hand, passes its income or loss to the owners, just like LLC’s and LP’s. However, because of this tax structure an S-Corp cannot become a public company unless it changes its classification to a C-Corp. Side note: LLC’s cannot be traded publicly, but can elect to become Publicly Traded Partnerships (PTP’s) or C-Corps to go public.
It is important to remember that you can change the classification of your company later, it is not set in stone. Given this, and given the nature of how taxes are calculated, a startup should always elect to start as a “pass-through” entity (SP, LLC, LP, or S-Corp) and never a C-corp.
Why a Startup Should Never Start as a C-Corporation
The capital gains tax on a C-corporation is only 15% because (it is assumed that) the corporation itself pays its income taxes. It would seem like a no-brainer to go with a C-corp because of the insane amount you would save come tax season. But what if your C-corp loses money?
The maximum deduction you can make for a capital loss in the c-corporation is $3,000, regardless of how much money you invested or how much the c-corp lost that year. In all other company formats, because the money is passed directly from company to owners and vice-versa, a loss means being able to deduct the entire loss.
In the real world, it takes time for a company to become profitable. The first year is extra tough and it is highly likely that the company will lose money, especially if it is started late in the year.
How This Translated to My Personal Life
Last year I created a C-corporation in Florida called Poker Systems Inc. I dumped about $6,000 into the company and realized it was going to fail before the end of the year, so I began the process of dissolving the company.
As I began to do my taxes, I learned that I would only be able to write off $3,000 as a capital loss. However, if the company is a pass through, such as an S-Corp, then I can effectively lower my income by the full amount I invested into the company. I filled out my tax forms for both structures to see the actual difference in dollars and it came out to approximately $1,000.
Luckily I hadn’t dissolved Poker Systems Inc at the federal level. Now my plan is to change the company from C-Corp to S-Corp, then file the taxes, then dissolve the company. This process will put $1,000 directly into my pocket.
I would have saved a whole lot of time if I would have just started out as an S-corp, knowing I can change the structure later if it succeeded.
Because startups tend to fail, and especially tend to lose money in their first year, they should always choose a “pass through” tax structure, which includes Sole Proprietors, LLCs, LPs, and S-Corps. But not C-Corps. This way, when tax season rolls around, all of the startups losses can be deducted by the people who actually lost that money.
This story is part of a series documenting the journey of a 2016 Dallas startup called Feather. If you would like to read more, here is the Table of Contents for the series.
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