Episode 442 | Corporate Structures and How the Choice You Make Now Can Impact You Years Down the Line

Show Notes

In this episode of Startups For The Rest Of Us, Rob and Einar Vollset talk through the different kinds of corporate entities, how they differ, and how they can impact you in the future.

Items mentioned in this episode:

Transcript

Rob: In this episode of Startups for the Rest of Us, Einar and I talk about US corporate structures, taxes, and why what you do now can impact you years down the line. This is Startups for the Rest of Us Episode 442.

Welcome to Startups for the Rest of Us, the podcast that helps developers, designers, and entrepreneurs be awesome at building, launching, and growing software products, whether you’ve build your first product or you’re just thinking about it. I’m Rob.

Einar: And I’m Einar.

Rob: And we’re here to share our experiences to help you avoid the same mistakes we’ve made. What’s the word this week, sir?

Einar: You know, it’s same old, same old. I’m mostly spending my time arguing with lawyers and accountants and things around Tiny Seed. That’s always exciting. It’s probably been since before MicroConf it’s been nonstop lawyering pretty much. That’s both expensive and frustrating at the same time.

Rob: Yeah. I was looking at some notes I had from a couple of years ago, I found this old notebook, and I had some personal goals that I didn’t announce in the podcast but personal goals for myself. One of the bullets was, “I don’t want to talk to any lawyers this year for any reason.” It was like 2017 or something.

Einar: It’s been unavoidable for me lately. Mostly with Tiny Seed stuff. Actually the main hurdle–which I guess we’ll get into this later–has been there are lawyers who specialize in whatever. You wouldn’t go to a securities lawyer if you need to be defended for a hit and run. But you talk to lawyers and their specialist and the expensive ones for securities and fund formation and they have their way of doing it, and it’s the way that venture capital is normally done. Essentially, you’re having to spend $1000 an hour arguing with somebody about how things should be done.

Rob: Right. Trying to educate them that we’re not traditional venture capital. It’s not going to all be Delaware or C Corps. We mentioned early on to the lawyers, we’ve been now through a couple of different firms but we told early on, it’s going to be more bootstrap startups, that’s our thing. We’re going to fund LLCs, we’re going to fund C Corps and they’re not all going to be in Delaware but then when rubber meets the road, all the docs made the assumption of Delaware C.

Einar: Delaware C Corp, a ban on issuing dividends which clearly doesn’t work with us, and all sorts of things. It’s been quite frustrating and a bit more expensive than I expected too.

Rob: Yeah. Because we’re just going against the tide of so many funds, right?

Einar: Oh yeah. The standard is like we only take Delaware C Corporations, at a corporate level disallow any kind of dividends because people want to reinvest and just do Delaware C Corps and that’s it and issue SAFEs ideally. The standard one, which again, assumes that there is a price around coming. That’s been interesting.

Rob: Yup. And that’s really the impetus for this episode is to give folks a little more background in case you don’t know who you are, you and I have co-founded Tiny Seed, we spoke about this about 20 episodes ago. It’s episode 420, an alternative form of startup funding where we talk to Tiny Seed and the mission and all that.

Einar: Yup.

Rob: Folks can go back and listen to that if they want more background. But you and I are in the midst of getting this off the ground and we’re picking the first batch and closing in all that stuff. But really, legal has now become the bottleneck and it’s getting these terms in there and as we were knee deep in this having these conversations via email when I was London and then get back in doing calls and stuff, you brought up. You’re like, you know there’s a lot of misunderstanding or just lack of knowledge with startup founders about the different entity types. Granted, this episode we’re going to focus on US entities, and there’s a few reasons for that.

One is even if you’re not in the US, a lot of folks do start US entities, they’re going to take any funding or if they’re going to cater to the US market or there’s tax reasons, there’s a bunch of reasons. If you’re living in Europe right now, some of this still may apply to you. You very well may wind up setting up a US entity at some point. But even beyond that, what I’ve often seen is while laws don’t translate one to one, there is generally in England, and in most of Europe, there’s the equivalent of these things, an equivalent of a C Corp that has double tax. And there’s equivalent of the LLC even though it’s not called the same thing.

Einar: That’s right.

Rob: The standard disclaimer applies, you and I are not lawyers, this is not legal advice and all that. But damn it, I kind of feel like I’m becoming a lawyer.

Einar: We’re going to go and ask all around, this is a plan whose […] all the Tiny Seed stuff and sign up […].

Rob: That would be my worst nightmare. We’re having to get pretty knee deep into it and I think the fact that traditionally bootstrapped companies typically form as LLCs or S Corps. And VC backed companies almost always form as Delaware C Corps, right?

Einar: The standard thing in YCs, you come into YC and you have A another entity, a foreign entity, or no entity, they kick you to I think it’s another YC Company, Clerky? And they just spin you up with like a, “Here’s how to do a Delaware C Corporation, that’s what you need in order to get the investment from us.”

Rob: Yup.

Einar: That’s very much to stay. With their investment structure, and YC is so dominant that pretty much whatever YC does on the accelerator early stage fund side, that’s what everyone else copies. It becomes a Delaware C Corp and a SAFE.

Rob: Right. What we’re going to talk through today is talk through the different corporate entities. We’re going to attempt and not make it the most boring episode ever of this podcast.

Einar: You should call it the most boring episode ever.

Rob: That should be the title, that’ll be something. And we’ll touch on points like liability versus taxes. Any tax is really the big thing with most of these, right? Because once you have an LLC, S Corp, C Crop, you do have a certain amount of liability shield. I’ve heard that if you’re a single member LLC in certain states, if you got sued, court will often consider you a sole proprietor, you don’t have a liability but we’re not going to get into that.

We’re going to talk a lot about taxes today because that’s the thing. Because if you pull dividends out, how are they taxed differently?

Einar: How you mean different? That’s the difference between a traditional YC Venture style company and like a bootstrapped “lifestyle” business. You’re going to basically go through several rounds of funding while you run at a loss. That’s the goal. It doesn’t really matter like tax optimization for dividends or the owners pulling out cash doesn’t really apply because there should be none. And in fact you might find that your investors are more than a little upset if you start actually running out of profit because that’s not the goal. The goal is become, burn all the money, dominate the market, and IPO.

Rob: Right. Raise every 18 months and if you’re not burning through that cash, you’re not spending it well, you’re wasting time and wasting their money. Because if they’re going to give you money and have you let it sit in your back account, it would be better served doing something else. That’s the mentality.

Einar: That’s true. Honestly, a lot of DCs will basically tell you they would prefer, like if you’re in a company that’s growing reasonably well. Tiny Seed or most bootstrap founders would consider a success so you get the $5 million, $6 million a year and you’re profitable but you don’t then need anymore a venture fund, that’s a loss for them. They would actually prefer you just to sell the company, pocket some money and try again and have a run at a bigger success.

Rob: Yup. That brings us into the meat of this episode. In the US structure, aside from just being a sole proprietor, there are really these three entities that are most common. I already mentioned them in this episode. Every Fortune 500 company I’m guessing is a C Corp. If you go public, you’re a C Corp. I don’t know that you can go public with other structures but that’s the big one and it’s as we’ve said, that’s what the venture capitalist typically Delaware C Corp. The nice part about that is there’s no past through income so that if you had a hundred different people on your cap table, you had a hundred different people or entities that owned a piece of your C Corp, at the end of the year, if you make a million dollars and keep it inside the company, nobody else gets taxed on it.

They’re like shielded from the taxes. It doesn’t count as income until you pull that money out of the company and actually distribute it to your shareholders.

Einar: Yeah, because that’s the challenge. That’s really the challenge with LLCs in that regard in general path through entities whether that’s partnerships, or a single member, or sole proprietor, or a C Corp doing it, S selection. You end up basically passing through whatever losses and gains to the people who own the company whether that’s investors or just the owners. You can be in a situation where there’s a gain but you’re not actually kicking out the gain so that there’s taxes to be paid but without any profits, any cash to pay for the investors. Which is partly why traditional venture funds don’t like to do it.

In some cases actually, the investors into the fund themselves, there’s a disregard of entities. They could be not for profits, they could be university endowments, they can be wealthy individuals who invest through like a self directed IRA. In most of those cases, they actually don’t pay taxes, so they don’t file tax returns. If you pass through a gain or a loss to them, all of a sudden they have to start filing tax returns not because of you, which is problematic in a lot of cases which is partly why it’s disallowed.

Rob: In my experience forming corporate entities, my consulting firm that then was this umbrella entity over all of my early small software products, and it still is frankly, I’ve changed the name of it now but it was called The Numa Group for years. I ran it for five years just as a sole proprietorship and then I made it an LLC. Certainly I wouldn’t have done a C Corp because I was just pulling up a bunch of cash off. That’s the thing we didn’t say.

The negatives of a C Corp, if you’re bootstrapped, the corporation itself will pay taxes at the end of the year and if you want to pull dividends out, you then pay another round of income tax. It’s called double taxation. If you’re pulling cash off a business, you do not want it in general to be C Corp. When I was forming The Numa Group as an entity and it was really more for liability reasons at the time just to shield me from anything. I could do an LLC or an S Corp and I was advised that an LLC, if you do a single member pass through LLC, that it has a less filing requirements, even less bookkeeping stringency complexity. I did that and that’s been fine. That was a good call for me.

When I went to spin Drip out, Drip started as just like hittail on all my other stuff, it was just under Numa Group LLC. Eventually, Drip got big enough for it has to be its own thing. When I spun that out, I could make it an LLC or an S Corp. Really, an S Corp as you said earlier, it’s just a C Corp with an S filing something or rather, like an option.

Einar: Yeah. It’s basically to do a federal taxes. You make what’s called a S Selection, and again, I am not a lawyer or a tax accountant, thank God, but you basically file an election with the IRS essentially you’ll be taxed in a very similar way to an LLC despite the fact that you’re a corporation. Doing so has benefits either from certain tax standpoints but it comes with certain issues related to it. For example, if you’re an S Corporation, typically becomes very hard to take investments, there’s a limit on the number of stockholders you can hold in the company, there is actually a limit on whether you’re allowed to have a non US persons as investors or owners. There’s a bunch of things that come into play there if you do the S Selection for sure.

Rob: Yeah. Because the advice we’ve been given is that Tiny Seed can fund C Corps and LLCs but we cannot fund the S Corps.

Einar: Definitely not, yeah.

Rob: Right. I didn’t know that. I believe it’s that another corporate entity cannot own a portion of an S Corp, is that correct?

Einar: I think that’s right.

Rob: Yeah. Again, not a lawyer but that was how it was explained to me but that was news because Drip was an S Corp and I didn’t realize when we formed it that that was a drawback. We hadn’t planned to take institutional funding. When we got acquired, I was looking around to try to do an angel round. That would’ve worked because it probably would have been a bunch of individuals but I just wasn’t aware of that at that time.

Einar: I think most people aren’t. You start up, people go to like Clerky or LegalZoom or ask their friendly neighborhood lawyer and it’s just like, “Oh yeah, yeah, yeah. Just do a single member LLC. Don’t think about it.” Or just do XYZ. in certain cases, people will optimize for their current tax situation but not necessarily for what’s going to happen if I want to sell the business or do a small angel round or that kind of thing.

Rob: That’s an interesting point because again, over the years when things were really simple for me, I just did an LLC and it filed its taxes as a sole proprietorship. Everything passed through to me, I didn’t take a salary. It was none of that. Now at a certain point, it started making enough money that my CPA said, “Look, keep it as an LLC but you file taxes as an S Corp and that allows you to now take a salary and you set a fair market salary, what does a CEO of a small software company make in the town you live in?” And since it was Fresno, it isn’t that high actually. “Everything above that, you just take out as an owner’s draw and then you don’t pay FICA,” is that social security?

Einar: Taxes and things or anything above that.

Rob: Yup. That’s a strategy that’s used by a lot of folks with both S Corps and LLCs filing as S Corps in essence. I think there are some number and I’ve heard varying, it depends on the CPA. My CPA said it’s when you’re making between about $60,000 and $70,000 from the entity. But I talked to someone the other day, they said their CPA told them $50,000 and someone else said $90,000. There’s some range in there.

Einar: My CPA is pretty mellow. She’s like I think $95,000. I live in the Bay Area too so she’s like $95,000 she’s fine with. I was like, “Why don’t we make it $50,000?” And she’s like, “Why don’t we not?”

Rob: Yeah. The salary?

Einar: Yeah, yeah, yeah. Because of the employment taxes in California held their own taxes on things on top of the Federal FICA taxes.

Rob: Right. It seems if you’re bootstrapping in business, the odds are pretty high. You’re going to do an S Corp or you’re going to do an LLC just because C Corp wouldn’t make sense. If you plan to raise venture funding, you’re probably going to go the C Corp route.

Einar: After you take funding from us. Maybe.

Rob: Yeah, exactly. Anyways, but it’s interesting because someone could go anywhere on the internet and research the taxes and stuff we just talked about but the interesting thing you and I are talking about before this episode started is the difference of if you decide to sell the company at some point, and the difference between if you never sold a company, you’ve never been thought about selling the asset within the corporate but not actually selling the corp itself versus a stock sale. Which is where you literally hand someone all the stock and they take the corporate entity with it.

Einar: Correct. Including the assets and liability crucially.

Rob: Right. That’s the thing that I’ve seen is, and you have more experience in this in the work you’ve been doing with Discretion Capital over the past couple of years. But my vague understanding has been that in smaller acquisitions, smaller meaning some $10 million, some $20 million whatever, they tend to be asset sales. Where you as the business owner, you keep the corporate entity and you keep all the liabilities in essence and the acquirer buys the assets, whereas if it’s some big, my guess is when Mark Zuckerberg bought Instagram, they probably bought all the stock.

Einar: Yeah. They bought the whole thing. Typically, a stock sale is essentially you’re taking the whole company, all assets, all liabilities, every single contract of this thing, including like if you buy a company and employee from three years ago sues you over something, sues the company, then you have to defend that claim. There’s a bunch of challenges around doing a stock sale. It includes the fact that if you purchase a company as a stock sale, that’s actually not as beneficial as doing it as an asset sale for the buyer.

With an asset sale, what you can do as a buyer, they come in and they say, “We want to buy just this specific piece. We might buy the technology, the goodwill, the existing contracts with customers, that sort of thing and we’ll explicitly exclude everything else.” Any liability that you sign, any contracts that they don’t want to assume, all that kind of thing will remain in the ship, was now essentially a shell entity. The other benefit which is often why buyers will push forward an asset sale, is that they get a tax break from doing an asset sale versus stock purchase so they often will pay more for exactly the same thing in an asset sale compared to a stock sale. And the specifics here gets into tax law and accounting. You definitely don’t want my advice on that.

Fundamentally, with an asset sale, what you’re able to do is to essentially reset the depreciation on those assets, and the value of those assets essentially becomes the purchase price. If you paid $5 million for an asset, my understanding is you essentially can reset the depreciation of those assets AKA those $5 million and then going forward, you can have that offset any income. If you’re doing a $5 million asset thing on something like this, it’s quite easily a million dollar tax break in the coming years which might translate to the buyers paying significantly more for an asset purchases.

Rob: The buyer gets that tax break, right?

Einar: Right. Essentially, you say like, “I bought this asset and it depreciates over time.” With the stock sale, you can’t do that. You’re just taking it over and essentially, you can’t reset the depreciation on the asset. Whereas with an asset sale, you’re allowed to do that which is so beneficial.

Rob: Right. Let me say that I bootstrapped a company, and for some reason I set it up as a C Corp because I think I’m going to raise funding at some point and I get acquired for $5 million but it’s an asset sale. Meaning they buy all the assets within the C Corp but I keep the C Corp. $5 million gets dumped into the C Corp, the C Corp pays income tax on that, then if I want to pull that money out to myself, I then pay my own personal income tax. You get double tax, it can be a huge amount of money, right?

Einar: It can be a really big difference. Because essentially, that corporate tax levels turn at least 21%. A lot of the time what happens is people essentially shot down the company because they sold essentially the core of it. They take the $5 million that goes in and then they’ll kick out whatever expenses they can but most people don’t have regular expenses that would wipe out $5 million. They then have to pay corporate taxes on it which is 21% and then they have whatever is left. At that point they can then pass it through to the owners. The benefit is that that can be long term capital gains, if you hold the company for long enough but it adds up quite quickly.

Rob: Whereas if you had that C Corp and it was a stock sale then, you would just sell stock and it’d be hopefully long term gains, assuming you own that stock for more than a year. But that’s the tricky part. Whereas if you had that S Corp and you would bootstrap it and it was an asset sale, then you’d save that 21% of extra tax. That’s the tricky thing. You don’t know what’s going to happen but you’re just doing your best to prepare for it.

Something you said to me, I’ve never heard of this but this almost sounds like a bizarre loophole is this qualifying small business stocks. Just to throw another wrench into this is if you have a C Corp and you’ve owned it for five years.

Einar: There’s a bunch qualifiers here. Although it’s like if you have the C Corp that was formed after this law came in. It’s a while ago now. Probably if you hold it for a fair amount of time, it’s probably after this date but essentially if after a certain date, if you formed it but on top of that you hold it for five years and it qualifies under these other criteria which I don’t have right in front of me but essentially they’re like sub $25 million or something like that and there’s a bunch of other qualifier stuff here. But if you do that and essentially your stock in the C Corp is counted as a qualifying small business stock, then you pay no federal taxes whatsoever including no long term capital gains.

Rob: That’s crazy. Is that if it’s a stock sale or an asset sale?

Einar: That would have to be a stock sale specifically on a C Corp.

Rob: Got it. Okay.

Einar: If you’ve done with an S Corporation election like a couple of years before, because that’s tax beneficial, then you don’t qualify.

Rob: There you go. It’s complicated stuff. I think what we’ve realized to turn it to Tiny Seed because we’ve been trying to figure out what can we fund, what should we fund. At this point, it looks like we’re able to fund C Corps and LLCs with some specific tax structures. I don’t think we can do individual single member LLCs due to some type of tax complexity or whatever.

Einar: Rob, it’s not even tax complexies. The fact that if we own a stake in that LLC it becomes a multi member LLC. It’s no longer a single member.

Rob: That’s right. You can’t do this thing. So it has to convert to a partnership. Now, it will mean that we have folks applying who might have a Colorado LLC so Tiny Seed will get a K1, which is an LLC equivalent of saying, “Hey, you own part of this and we file taxes and here’s a document showing how much your portion made or lost.” And then Tiny Seed will likely have to file a state income tax return in that state.

Einar: Income taxes and yeah, there’s actually even a question about whether our investors will then have to turn around and find their own income taxes in various plates. There’s a reason why the lawyers say, “You know just do the SAFE and the C Corp,” and why it’s more complicated doing this the other way. Certainly, most venture investing isn’t setup to do what we’re trying to do.

Rob: Right. And that’s been one of the challenges, that’s also one of the ways that we’re trying to change this, right? Is change this landscape to allow people to have an LLC and to take funding from essentially, it’s institutional. We are institutional money technically because we are investing our own money but in addition to other people who have put the money into our fund.

I think that sums up the feelings and the hots that we’ve been digging into all the stuff surrounding these corporate entities because frankly, I’ve been running a business for approaching 20 years now, different businesses. I felt like I had a handle on most of this and it turns out everytime I dig into this stuff I learn something new about it.

Einar: Yeah. That happens to me too. I had a conversation with somebody and this qualifying small business talk thing. He was looking at the sales business and I told him, and it turns out he qualified and he was quite surprised. Pleasantly so, I think. It’s an odd thing. You got to think about how easy is it to convert between the various things. If you’re already filed as an S Corp, it’s not actually straight forward, just to go back to a C Corp. There are some hangovers there.

Actually, different states treat these things differently. It’s not easy. It’s actually quite hard for us, I think that people come and they’re like, “What should we do? Should we do an LLC or an S Corp? Or a C Corp? What should we do?” In part, it’s up to them. They have to decide what they think is the most important. We can only sort of just lay it out for them to say, “Okay, here is the pros ann the cons.” It depends roughly what you’re looking to do.

Rob: Because if you wind up selling in an assets sale versus a stock sale versus never selling and just run and pulling dividends out being profitable, each of those has its own ideal structure.

Einar: I think that’s true. At a very high level, I think it’s fair to say that if you don’t think you’re going to take a bunch of investment, if you don’t think you’re going to IPO or sell for hundreds of millions of dollars, you can imagine this business becoming something that sells for sub $20 million say, then chances are that with the tax structure and the fact that you’ll probably get more money for an asset sale versus a stock sale, you’re probably better off with an LLC, I should think. But it’s hard to know. Who knows that any given company can turn around and becoming much bigger than you thought and then you have to deal with the headaches for the choices you made earlier.

Rob: Yep. Talk to a lawyer for sure. I did when I spun Drip out. It was essentially just an asset under that umbrella corp I had. While it was painful and took a few months, I basically spun it out into its own S Corp and all that worked out well. These things are doable. It’s just how complicated, how further the line you are, if it’s a taxable event.

Einar: That’s part of the main thing. There are certain things that are easy, like you can go from one to another and might be easy but going back might be hard or might be delayed or take time or have tax implications. There’s a reason tax accountants get paid so much money.

Rob: Indeed. Hopefully we haven’t bored you to death today for those of you who are still with us.

Einar: I’m feeling kind of sleepy.

Rob: You got to go drink some coffee. If you have a question for us, not about this topic because I hope to never speak about it again, you can call our voicemail number at 888-801-9690 or email us at questions@startupsfortherestofus.com. Our theme music is an excerpt from We’re Outta Control by MoOt, used under Creative Commons. Subscribe to us on iTunes by searching for ‘startups’ and visit startupsfortherestofus.com for a full transcript to each episode. Thanks for listening and we’ll see you next time.

 

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