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The Never Ending Tax Blog: Brief Answers to All Your Tax Questions

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.

Any questions?

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Comment by Douglas Levin on March 29, 2009 at 5:28pm
Bruce: yes, other entities can be later converted to C corporations, but as you probably know it's much more difficult to go the other way. You also mention the At-Risk and the Passive Loss rules, which if carefully managed could leave you able to take ordinary losses instead of capital losses if they investment doesn't work out - again something a C corporation just can't do for you.

Patrick: thanks for the welcome, I'll be here if you have any questions.

Daniel: thanks for the brief resume blog. If you follow me on twitter not all my posts will be professional in nature, but that's what makes it fun.

Kurt: adding to your comments on royalties: whenever possible establish that entity outside the state of Hawaii. If correctly structured with royalties sourced outside the state, you may be able to avoid GET tax on that income. Consult your tax adviser, as it's easy to err here.

EVERYBODY FEEL FREE TO ASK QUESTIONS ON THIS BLOG ANYTIME! Most blogs eventually die off from lack of topical interest, but you can't ever run out of material here. Just ask away. I'm probably not going to post unless someone asks a question, but we'll see whether people stay interested for the long haul.

One last thing that will apply to everyone's posts here I should have included in the first one. Whatever is shared here should not be considered tax advice. Always consult your tax adviser before taking any action based on comments in this blog, including mine. There are always exceptions to the general rules, and tax planning is notoriously rife with "gotchas" you don't want to learn about after the fact. Be careful out there.

If you're not sure if you tax adviser is giving you good information, feel free to run it through here if you don't mind sharing with everyone.
Comment by Kurt Sussman on March 29, 2009 at 8:22am
I'm very happy to see this blog here! Thanks Doug!

I've sometimes been advised to hold the IP in an LLC, which can be transferred with the C corp that makes use of the IP on sale, or not. If you sell the company that makes use of the IP, one way to get paid in a tax-sensitive way is to keep the LLC and take royalties for the use of the IP. Slightly more complicated, but more exit options.

OTOH funding is trickier because of this split; as an angel or VC, which part would YOU want to own? My answer is 'both'. And LLCs have limits on the number of shareholders, so if your investors want a piece of the LLC, you can only sell a limited number of pieces.

But if you're building a lifestyle business (one you want to keep forever), this may be worth looking into (with your legal and tax team, of course!).
Comment by Daniel Leuck on March 29, 2009 at 7:47am
We really like the idea of a never ending tax blog for techies! You are, to my knowledge, the only CPA in Hawaii blogging tax advice for techies.

For those of you who don't know Doug, he is a Hawaii Angel and cofounder of Levin & Hu, LLP. One of his firm's specializations is dealing with Qualified High Technology Businesses (Act 221.) You can read more about them on Doug's profile page and follow him on twitter.
Comment by Patrick Ahler on March 29, 2009 at 5:58am
great post! I'd love to see more of these
Comment by Bruce M. Bird on March 29, 2009 at 5:42am
Hi, Douglas. Great idea for a blog !

One point I would like to add is that an entity started as a "pass-through" --such as an S corp, LLC, etc-- can later be converted to a C Corp. This may make sense where 1) the owners satisfy the "at-risk" rules; 2) the owners materially participate in the business; and 3) the entity is expected to lose money in its early years.

Your point about the owner of a "cash cow" business wanting to operate it as a "pass-through" entity rather than as a C Corporation is well-taken.


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