Build It So They Will Come

Successfully sell an S corporation, and you’ll benefit from the same tax treatment that governs profits: the sale’s proceeds are taxed once. Passed-through losses, however, can lower a seller’s basis, or what’s considered the seller’s initial cost for the purpose of computing capital gains. That can in turn increase the amount of tax due on the gains. “That can   be unpleasant if you’re selling,” says Michael Schley, a partner at Bloomington-based law firm Larkin Hoffman Daly & Lindgren, Ltd. On the other hand, he says, the pass-through also “increases your basis to the extent you had income.”

C Corporations: The Industry Standard

C corporations, and particularly C corporations formed under Delaware law, have become the industry standard for raising capital, as Windlogics found. That’s partly because venture capitalists, other investors, and the legal community are most familiar with that structure.

“Most entrepreneurs will find that C corporations are either strongly preferred or a requirement for raising institutional capital,” Gorman says. “There’s a preference for the predictable elements and established laws under Delaware C corporation law, because that’s the most fully vetted law. You can get the most clarity with it, which is to everyone’s benefit.”

Though venture capitalists often prefer C corporations, they’re not the best choice for every company. The C structure offers liability protection, as an S corporation does, but taxes profits twice, as both company and personal income.

For investors, though, C corporations offer flexibility. Investors are not limited in number and can be corporate entities. C corporations can also have multiple types of stock, including common and preferred stock, and can issue options and warrants, another feature that venture capitalists like, because it helps principals and employees focus on the company’s success. “We like to see an option pool for management and employees,” says Joy Lindsay, president and co-founder of Bloomington-based StarTec Investments, LLC, a private venture capital firm. “Employees often aren’t paid market rate in early stage companies, because the company can’t afford it, and options are their incentive, offsetting compensation.”

A C corporation’s double taxation can be a burden for an entrepreneur, but venture capitalists like it, because it doesn’t require the S corporation’s automatic pass-through of profits and losses to investors. Instead, profits and losses stay within the company.

“We’re not looking to reduce our taxes in the early years,” Lindsay says. “As companies are able to achieve a net gain, we’d like to see those funds invested in the company, so they continue to grow.” Losses also stay within the company, where they may attract buyers who want to offset their own company’s gains.