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The most common type of entity in which you will likely invest will be a Delaware C corporation.
A C corporation is a type of business entity which is taxed for federal income tax purposes under Subchapter C of the Internal Revenue Code. C corporations pay the taxes that are due on their income; their shareholders are not taxed on and not liable for taxes on the corporation’s income (in contrast to S corporations and limited liability companies, which are taxed as partnerships).
As we discussed in Legal Due Diligence for Angel Investments, Delaware is the most popular place for early-stage companies to incorporate because of the state’s corporate law history and the business-friendly legal precedents there. Delaware corporate law is also the most familiar to the investment community.
Tax Issues With Investments In C Corporations
Investors prefer C corporations because the C corporation pays its own taxes, and the investor is not taxed on the income of the company. If you invest in an S corporation or an LLC taxed as an S corporation or partnership, you will be taxed on the income of the entity, even if the entity doesn’t distribute cash to you to pay the tax.
important When you invest in a C corporation, you generally do not get a tax break or a tax credit or tax deduction at the time of your investment. Unfortunately, for federal income tax purposes, when you buy stock in a C corporation, your purchase price goes into the cost basis of the stock you acquire. You don’t get to recover* that basis until you sell the stock or the stock becomes completely and totally worthless.
Qualified Small Business Stock
There are special tax breaks for investing in certain types of startups, however. For example, Section 1202 and Section 1045 of the Internal Revenue Code are designed to encourage investment in C corporations engaged in qualified trades of businesses with less than $50M in gross assets (both before and after the investment).
Section 1202 provides a special incentive for investments in qualified small business stock (or QSBS). QSBS is stock of a C corporation actively engaged in a “qualified” trade or business issued to an investor when the C corporation had less than $50M in gross assets (both before and after the investment). “Qualified” trades or businesses are generally not service-based businesses. Under Section 1202, if you hold the QSBS for more than five years, you get a tax break on your long-term capital gains tax rate.
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The statute refers to “qualified trade or business” as “any trade or business other than”:
⚖️legalese(a) 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,
(b) any banking, insurance, financing, leasing, investing, or similar business,
(c) any farming business (including the business of raising or harvesting trees),
(d) 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
(e) any business of operating a hotel, motel, restaurant, or similar business.
important The The tax break is currently a 100% exclusion from federal income tax entirely,* on up to the greater of either $10M in gain or 10x the aggregate adjusted basis of QSBS issued by the corporation and disposed of by the taxpayer during the taxable period. Basis for 1202 purposes is not less than the fair market value of property exchanged for QSBS. This is a very significant tax break. But it is only available to investments in C corporations, not S corporations or entities taxed as partnerships, such as multi-member LLCs that haven’t elected S or C corporation status.
If you sell QSBS before holding it for five years, you can roll over your gain under Section 1045 into another qualified small business, provided you make the rollover investment within 60 days. Section 1045 is potentially very helpful, but the 60-day rollover window might be hard to make. It usually takes much longer than 60 days to find an investment. One suggestion to Congress to improve the law is to allow for more than 60 days to make a rollover investment.
Investing in S Corporations
You might be interested in investing in an S corporation.
Shareholders in S corporations can generally only be individuals who are U.S. citizens or lawful permanent residents. Shareholders cannot be other business entities or organizations. When a venture capital firm invests in an S corporation, that companies loses their S corporation status and convert automatically to a C corporation.
caution S corporations can only have one economic class of stock. Meaning, you will only be able to buy common stock; you won’t be able to buy preferred stock.
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