Angels invest with hard cash, while founders provide “sweat equity.” Hence, investors often ask for special rights and preferential treatments in exchange for their investment. But this can’t be done with S Corps because, as we’ve noted, only one class of stock is allowed.
* This is an excerpt from a special report. Download full report at “C Corps vs. S Corps vs. LLCs: Which Corporate Structure to Angel Invest in and Why the Form of Entity Matters.” Again, this is not legal or financial advice. Please consult with your lawyer and accountant.
Having only one class of stock means that equal rights must be given to all shareholders – no special rights or preferential treatments can be granted. For this reason, experienced investors typically require an S Corp. to convert into a C Corp. or LLC before backing the company.
C Corps can have different classes of securities while LLCs can have multiple classes of units. Both structures are free of the one-class stock restriction inherent in S Corps. Still, it appears that in this instance, at least, the C Corp. is the more favorable structure. Let’s see why.
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While LLCs offer short-term tax efficiencies with its flow-through ability, the C Corp. structure offers a number of potential benefits upon successful exits.
For example, you can “achieve a tax-free exit through a stock for stock exchange with another corporation,” ACEF reports. [3] “There can also be favorable capital gains in tax rates for early stage investors in certain C corporations that have raised less than US $50 million.”
In addition, if you hold the stock for more than five years, you may cut half of your tax payment upon a liquidation event. “If you think there is going to be big home run, paying 7.5 percent instead of 15 percent can be a huge advantage,” says Jeff Solomon of LKN+S.
Subject to specific conditions in the Internal Revenue Code (IRC) and the type of C Corp. you invested in, you may treat the losses as ordinary, rather than capital, losses, which may result in higher personal tax savings. If there are profits, you may roll them over into a future investment to postpone tax payments.
Talk with your tax specialist to see which (legal) tax minimization strategies you’re eligible to implement.
Because LLC members own membership interests rather than stocks, members aren’t entitled to the benefits tied to stock ownership, as discussed above.
However, in certain exits, the benefits of an LLC’s flow-through ability can be substantial. For example, in an asset-sale type of exit, the proceeds will be taxed only once as opposed to twice in the C Corp. structure, according to Adrienne Randle Bond, an attorney who specializes in partnership and securities law and mergers and acquisitions. [6]
* This is an excerpt from a special report. Download full report at “C Corps vs. S Corps vs. LLCs: Which Corporate Structure to Angel Invest in and Why the Form of Entity Matters.” This is not legal advice. Please consult with your lawyer.
