The majority of angel and venture capitalists (VCs) will only invest in C businesses (C corps).
C corporations are popular among investors and venture capitalists due to the way they are taxed. C corp shareholders, unlike LLC members, only pay taxes on corporate income if they get a dividend (distribution).
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C Corporation Taxation vs. LLC and S Corporation
C firms pay taxes on their net profits after deducting all operational expenditures. The gains are subsequently distributed to shareholders, who pay income tax on the distributions.
This implies that shareholders, including investors and venture capitalists, are only taxed on money distributed (or paid) to them.
This is also known as “double taxation,” since the company’s income is taxed twice: once at the corporate entity level and once at the individual shareholder level.
Taxation of LLCs and Venture Capital/Investors
LLC members pay taxes on their part (as a percentage of ownership) of the LLC’s earnings, whether or not they received a payout.
It’s easy to see why an investor might object to paying taxes on money they didn’t get. It is also difficult to transfer ownership of an LLC, to the point that investors would prefer not to deal with it.
Taxation of S Corporations and Venture Capital/Investors
Venture capitalists prefer C companies over S corporations (S corps) because, like an LLC, a S corp investor or VC must pay taxes on the S corps earnings even if they do not get a payout.
S company taxes legislation differs by state, making accounting more difficult for investors.
C Corporation Advantages for Investors and VCs Investor-Friendly Taxation
Unlike other business arrangements, C corporation shareholders only have to pay taxes when the firm pays them dividends.
In the case of an LLC, regardless of whether they get a dividend or not, all owners pay tax on the company’s yearly profits. This is one of the main reasons investors like C corporations: they only have to worry about paying taxes on the money they actually get.
Filing for Investors
C corporations are also preferable to investors and venture capitalists owing to the manner their taxes are filed with the IRS. When investors purchase a portion of an LLC, they must wait until they get a K-1 form from the LLC before filing their own personal taxes. This may make the filing procedure more difficult for the LLC’s passive shareholders.
C corporations have a more simpler tax filing procedure, which is another reason why they are the favored entity option for investors.
Simple Ownership Transfer
Investing in a C corporation entails owning a portion of the company’s stock. Investors and venture capitalists are given a particular number of shares in exchange for a proportion of earnings.
LLCs, on the other hand, must change their operating agreement to accommodate new investors and alter ownership of the firm. Because this procedure is more cumbersome, it is sometimes simpler to just invest in C corporations.
Exit Strategy by Nature
When investors and venture capitalists are ready to depart a firm, they must have an exit plan in place. Selling your ownership in a firm, whether it’s shares in a corporation or units of ownership in an LLC, is a frequent technique for leaving an investment.
Selling an LLC’s ownership is a reasonably easy process: you can either find a buyer to take over your portion of the firm (with the approval of the other owners), or you may cede your percentage to the present owner(s) for a fixed fee. In any event, the proceeds from the sale of the LLC are subject to considerable government taxes.
Exiting a C company, on the other hand, is often a tax-free transaction. Due to Section 1202’s Qualified Small Business Stock exemption, investors who have maintained a common or preferred stock investment for 5 years or longer may be allowed to cash out without paying taxes on gains up to $10,000,000.