This is the first post in what I hope becomes a continuing blog with answers to the basic tax and accounting questions you technical specialists may have. Just ask away, and when I get the chance I'll answer your posts so you can run your companies right.
To get us started, my first blog post is on the subject of choice of entity. As with all of them, I'm going to keep it brief.
Most venture capitalists prefer C corporations for two primary reasons: they're self-contained little tax entities, and their exit strategy is usually just that, to exit. By being C corporations they avoid having to provide K-1's to shareholders and partners, who then would have to report their respective share of income or loss on their individual tax returns. This keeps all tax compliance stays within the entity itself. Then when they do exit, they usually swap their shares for either cash or stock or some combination of those in an IPO or acquisition (they DO NOT do asset sales).
However, C corporations are not always the perfect entity. Pass through entities like S corporations, partnerships and LLC's are more complex to administer but for the right situation can save considerable amounts of tax. If your long term plan is not to sell out, then Uncle Sam will take a much smaller bite if you've set your company up as one of these. This is because unlike a C corporation, there is only one layer of tax not two. C corporations pay tax at the entity level, then when they put cash in their owners hands by paying dividends those payments are taxed a second time. However, for pass through entities the company itself pays no tax! Instead only the owners pay tax on their respective share of that entities' earnings.
It a very rough rule of thumb but if your 'exit' plan is not selling but rather keeping a cash cow (a company throwing off considerable profit you want to keep) you'll find pass through entities leave much more profit in your hands than a C corporation ever would.