What Angels Need to Know About Business Entities and Taxes
23 minutes, 4 links
Updated September 19, 2022
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In Part III: Financings and Term Sheets, we covered the most common investment scenarios. In this section, we will review the most common types of entities in which you might consider investing, as well as the relevant tax issues that arise.
Angel investing involves a number of different tax issues for investors. You might wonder, for example, when can you recover your investment in a company for tax purposes? Can you deduct your investment in the year you make the investment? Is there a tax credit for making the types of investments you are making?
The tax consequences of any particular investment will depend on the type of entity in which you invest—typically either a C corporation, S corporation, or LLC taxed as a partnership—and how you invested—stock purchase, convertible debt or convertible equity, interest in an LLC taxed as a partnership, and so on.
Investing in C Corporations
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.
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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.
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 tax break is currently a 100% exclusion from federal income tax entirely,* on up to $10M in gain. 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.
An S corporation can divvy up governance rights as long as the economic rights of all of the shares is the same (for example, an S corporation can have voting and non-voting stock, as long as the voting and non-voting stock have the same economic rights).
Tax Issues With S Corporations
cautionIf you invest in an S corporation, you will be taxed on your proportionate share of the entity’s income, even if the company does not distribute any cash to you with which to pay the tax. (In contrast, to repeat, C corporations pay tax at the corporate level and thereby shield you from any direct tax consequences.)
If you want to make sure that the company distributes cash to you so that you will be able to pay the tax on the entity’s income that you are taxed on, you will have to enter into an agreement with the company that expresses this, and it should be part of your term sheet. One positive aspect of investing in S corporations is that if the company has an operating loss, you will be allocated some portion of those losses to report on your individual tax return.
caution However, be aware your losses may be limited by the passive activity loss rules.
dangerAnother thing to watch out for: If you invest in an S corporation that does business across a number of states, you might have to pay income tax, or, in the event of an operating loss, still file a tax return in those states even if you don’t live in or visit them.
Investing in LLCs
Sometimes founders form LLCs as an easy way to get started.
Limited liability companies (or LLCs) can be simpler to form than corporations. LLCs also have the benefit of being pass-through entities for tax reasons by default. Meaning, the losses flow through to the personal tax returns of the owners, unless an election to be taxed as a corporation is made.
important The financial and tax consequences of your investment depend on how the LLC is taxed for federal income tax purposes. This is a legal and business due diligence point you will want to run down right away.
It is not uncommon for founders to have forgotten what their tax accountant did when they formed the company. If you are considering investing in a business organized as an LLC, you must confirm the tax classification of the LLC. It is preferable to do this sooner rather than later. Don’t assume that because the company is formed as an LLC that it is taxed as a partnership. For federal income tax purposes, an LLC can be classified as either:
a disregarded entity (if it is owned by one person);*
an S corporation; or
a C corporation.
caution You will want to know the tax classification of the entity sooner rather than later in your investment process because investments in pass-through entities give rise to a number of issues that you might not want to spend time confronting.
If the LLC is taxed for federal income tax purposes as a partnership, but it intends to convert to a C corporation later, you may want to require the LLC to convert to a C corporation prior to your investment. If you invest in an LLC taxed as either a partnership or an S corporation, you will be taxed on the LLC’s income even if no cash is distributed to you to pay the tax. In other words, investing in an LLC can unnecessarily complicate your personal tax situation. See the tax issues section below.
You may, however, want to invest in an LLC taxed as a partnership that intends to stay an LLC taxed as a partnership. In addition to the single layer of taxation and its ability to pass through losses, other advantages of retaining the LLC form include the abilities to:
allocate income and losses in a manner disproportionate to ownership;
spin off or split up assets or businesses in a tax-efficient manner; and
consummate an asset sale and have the gain largely qualify as capital gain.
It is not always the case that investing in an LLC is the wrong choice. But be careful, because it frequently is. Below we will discuss some of the challenges with investing in LLCs and some things to watch out for.
Tax Issues With LLCs Taxed as Pass-Through Companies
LLCs with multiple owners who do not make any special elections are taxed as partnerships for federal income tax purposes. Under the federal tax law, partnerships do not themselves pay the federal income tax on their income. Instead, their owners pay the federal income tax on their share of the income allocated to them. This can be problematic for an angel investor for a number of reasons. See the discussion about investing in S corporations.
cautionIn this section we discuss the potential problems of investing in an LLC taxed as a pass-through company:
Pass-through taxation. If you invest in an LLC taxed as a pass-through company (meaning, either as an entity taxed as a partnership or as an S corporation), the LLC itself, as an entity, will not pay any federal income taxes. Instead, its owners will have to report on their tax returns and pay the tax on the income that the LLC generates—even if the LLC does not distribute any cash to its owners. Most angel investors do not want to invest in a company that will cause them to have to pay tax on the entity’s income, regardless of whether any cash is actually distributed to them.
Investors in LLCs should consider ensuring that the LLC agreement requires the LLC to distribute sufficient cash to owners so that you may pay the tax on the LLC’s income allocated to you. However, some LLC agreements do not mandate tax distributions.
State income taxes.LLCs are also problematic for state income tax purposes. If you invest in an LLC, you might become liable for state income taxes in states in which the LLC does business but in which you are neither a resident nor a visitor. For example, an investor who is a resident of a state such as Washington, which does not have income tax, may become subject to income taxation if they invest in an LLC doing business in a state with income tax, such as California. This could be a very unwelcome and expensive surprise.
No qualified small business stock benefit. Another negative aspect of investing in LLCs is that LLCs cannot issue qualified small business stock. Qualified small business stock is advantageous because it may qualify for special reductions in long-term capital gains tax treatment on sale (including up to 100% of the gain being excluded from tax entirely). This is not possible with LLCs.
Difficulty with understanding allocations.LLCs are also problematic because of the complex tax rules governing how income is allocated to the owners. You might receive a Form K-1 from an LLC, indicating your distributive share of the LLC’s income, loss, expense, credit, and other tax items—and not understand what it is you were allocated or why.
Delay in tax documents. If an LLC sends you a Form K-1 for your taxes, you may not receive that document until September following the end of the tax year.
Challenges As A Minority Investor In An LLC
Another problem with LLCs is that the LLC agreement may contain a variety of provisions that are detrimental to the LLC’s minority owners. For example, because the LLC agreement is a contract in which the LLC members can essentially agree on anything (to waive fiduciary duties, for example), it has to include an amendment provision specifying how the agreement can be modified.
caution Companies are not going to want to have an amendment provision that requires unanimity, because that would hamstring the company and give any one member the right to hold the company up. As a result, if you are a minority investor in an LLC, you are probably going to be asked to sign an agreement that says it can be amended without your consent. This might make you uncomfortable.
You may want to ask for protective provisions, meaning special voting rights of just the investors, just as you can when investing in a corporation. It is possible to negotiate for just about any type of special voting rights you want in an LLC.
At the very least in these situations, you should ask that the amendment provision be written such that no amendment can single out or treat any member differently from the group, or require any one member but not others to put in additional capital, guarantee any debt, or otherwise cause any member to have a personal liability. Additionally, you may want to specify what types of amendments require your consent—such as requiring the members to contribute additional capital.
Potential For Capital Calls
importantAs alluded to above, an LLC agreement could specify that a manager or a majority of the members can require capital contributions from all members. Review the agreements carefully to insure that you will not be on the hook to make a larger financial commitment than you had intended. Make sure your investment documents don’t obligate you to put more money into the company. This is not an uncommon provision in an LLC agreement.
exampleJoe knew an investor who invested in a bar, and the LLC agreement obligated all of the members of the LLC to put additional capital in upon the majority consent of the members. This was basically a blank check the investor was signing up for!
Investor Protective Covenants
You can ask for all of the same investor protective covenants in the LLC context that you can ask for in the corporate context. Those might include:
Information rights. For example, the rights to receive regular accounting reports, and have access to accounting information.
Disclosure and approval of conflicted transactions. In other words, the investors must approve insider transactions* after disclosure of all material facts related to the insider transaction.
Right of first refusal. Meaning, the right to be the first to purchase shares other members are selling.
Co-sale rights. The right to sell your shares alongside the founders, if the founders are selling some or all of their shares.
Participation rights. The right to buy more shares if the company sells more in an equity financing.
caution If the managers can indebt the LLC or require capital contributions, you may want to exit the LLC immediately. But frequently, LLC agreements preclude an owner from exiting or withdrawing.
If you invest in an LLC, you might want to negotiate for the right to withdraw from the LLC and convert your interest into the right to receive an amount of cash upon written notice from you under certain circumstances, such as:
The LLC fails to give you the information you need to file your taxes in a timely manner.
The LLC fails to observe your information rights or other rights you’ve negotiated.
Another approach is to invest through an LLC that you create and own specifically for making investments. With this approach, if your LLC becomes liable somehow to the portfolio company, then at least that liability will not become your personal liability, but will only be the liability of the LLC you formed to make the investment.
Non-Compete, Non-Solicitation Agreements
Frequently, LLC agreements will include non-compete and non-solicitation (of customers and potentially employees) provisions that attempt to:
bind all owners regardless of whether the owner provides services to the company (this doesn’t make sense, but is common), and
broadly apply to any and all businesses whatsoever that the LLC is currently engaged with or becomes engaged with.
caution These provisions can be problematic if you have investments across the industry. If you are not a service provider to the company, or if you were once but are no longer a service provider to the company, you should not be bound by a non-compete or non-solicitation agreement.
LLC Agreements Are Complex
LLCs are also problematic because LLC agreements can be long and difficult to understand. The statutes under which LLCs are created typically allow the parties to contractually agree on anything. This means LLC agreements wind up covering a lot of different subjects. To give you a short list, your average LLC agreement will contain provisions addressing the following:
new member admission
transferability of units (more specifically, restrictions on transfers)
amendment of the agreements
LLC agreements may also contain buyout provisions.
Shortlist of Questions for Consideration in Becoming a Minority Member of an LLC
important If you’re considering becoming a minority member of an LLC, make sure you’ve asked and have received satisfactory answers to the following questions:
Are you on the hook for anything personally, or could you be on the hook for anything personally?
Do you have the right to withdraw from the LLC, or are you stuck?
Can the majority members amend the LLC agreement without your consent?
Does the LLC agreement bind you to a non-compete, or a non-solicit?
Have you confirmed the LLC’s tax status? Did it check the box to be taxed as an S corporation?
If the LLC is taxed as a pass-through company, does the LLC have to distribute cash to you so that you can pay the taxes on the LLC’s income?
Do you have voting rights? Are they meaningful or are you such a minority that it won’t matter?
Does the LLC agreement say that conflicted interest transactions have to be approved by at least two independent managers or owners (members) who are not conflicted?
Do you have good information rights?
Are there transfer restrictions on your units? Can you sell your units? Can others sell theirs despite the fact that you can’t sell yours?
Do you have co-sale rights?
Are your units subject to rights of first refusal?
Do you have participation rights in the company’s next financing?
Are you subject to a drag-along agreement? Is it suitably drafted?
Have you confirmed that you will not be taxed as a result of your admission to the company?*
dangerPlease always consult with your tax advisors regarding credits and losses and other tax matters. Tax law changes frequently and the summaries in this book may not accurately describe how the rules apply to your particular situation.
The federal income tax law does not, in 2020, provide a tax credit for investing in startups. However, the state in which you live, if it has an income tax, might. You should consult your local tax CPA to find out what incentives your state might offer.
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