Saturday, February 14, 2009

Start Ups: Subchapter S or C-Corporation Status

For a long time I have debated with an accountant friend whether Subchapter S is really necessary for a new corporation. My starting point has been that the tax savings for a Subchapter S do not exist unless you have a C-Corporation paying dividends. Let me now add

Venture Capital investments in C-Corporations from to the mix:
In most circumstances, a company must be a C-Corporation when taking investments from venture capital firms. There are a few reasons for this:

1. VC Limited Partners (LPs) contractually obligate the VC General Partners (GPs) to avoid any pass through tax liabilities that may result in an investment into a portfolio company that wasn’t a C-Corp.
2. Even if the company was a non pass-through tax entity (like an LLC with an election to be treated as a non pass-through entity), the governance of the company would be non-standard as compared to a C-Corporation. VCs focus on C-Corps, and even though it is possible to invest in an entity like an LLC, they don’t to avoid complexity.
3. Lastly, if the company was an S-Corp, the company would immediately be converted to a C-Corp when a VC invests, as the fund is a non-person. See this post for more information.

In essence, my first concern with a business that wants to be a corporation is with structure and tax issues revolve around the issue of structure. Accountants think first of taxes. Bottom line is that the business needs to know what it wants so that the best structure with the best tax consequences can be created by the accountant and the lawyer.