Should You Pay Corporate Tax?
Written By Adam Yohanan
Let’s talk about how your startup can avoid corporate tax.
When you form a new business, one of your first decisions will be the legal and tax structure of the business.
In order to legally form the entity and pay taxes, you will need to choose a legal and tax structure. Let’s break down the two types of structures:
Structures that require you to pay corporate tax
Structures that allow you to avoid corporate tax
Since there is an option to pay the 21% corporate tax or avoid it, why would any startup choose to pay the corporate tax?
Because for startups that plan to scale fast using institutional investments from venture capital funds, Corporations taxed as C Corps are preferred by investors, even though this structure is subject to corporate tax.
On the other hand, if the new business does not plan to grow fast or plans to scale fast without institutional funding, the business can usually choose a legal and tax structure that does not require the business to pay corporate tax.
Many legal and tax structures allow the business to avoid corporate tax.
To understand this, note that the legal classification of the entity (LLC, Corporation, Partnership) is different than the tax classification of the entity (Pass Through, S Corp, C Corp, Partnership).
So every business will have both a legal classification and a tax classification. There are many potential combinations of legal and tax classifications. In the examples below, some combinations pay corporate tax and some do not.
Corporate tax:
Corporation taxed as C Corp
Other entities taxed as C Corp
No corporate tax:
Corporation taxed as S Corp
LLC (Single Member) taxed as Pass Through
LLC (Multi-Member) taxed as Partnership
LLC taxed as S Corp
Partnership taxed as Partnership
Partnership taxed as S Corp
Of all the potential legal and tax combinations, the one preferred by venture capital investors happens to pay corporate tax: Corporation taxed as C Corp.
This institutional preference for Corporations taxed as C Corp creates a difficult trade off for entrepreneurs. You need to find a balance between minimizing taxes and attracting investors. Do you appease investors and pay corporate taxes, or do you minimize taxes by choosing a different structure.
The right path often comes down to profitability timeline.
If your business will not make profit for the foreseeable future, then you should consider the Corporation taxed as C Corp.
The reality of business today is that if your venture will not make a profit in the foreseeable future, you will need to seek outside capital to keep the lights on. Sometimes this can be done with friends and family, private investors, or local institutions. But a lot of the time it cannot be done without the help of institutional investors, especially if it’s a big project.
The good news is that if you won’t make profit for a long time, you don’t need to worry about paying corporate tax. You will start to pay corporate tax once you start to make a profit.
Therefore, unprofitable businesses with plans for rapid growth should consider C Corp despite the corporate tax.
If your business will be profitable early, and you aren’t sure yet about institutional capital, you may be better served by a structure that does not pay corporate tax.
In most cases, you can shift to a C Corp later if necessary. But in the short term, the entrepreneur should consider the financial impact of the tax burden. The entrepreneur should weigh the cost of the tax burden against their degree of certainty that their startup will require institutional funding.
If your degree of certainty that you will need institutional funding is low and your profits are high, you should generally stay away from the C Corp and avoid unnecessary exposure to the 21% U.S. corporate tax.
Adam Yohanan is a transactional business lawyer with extensive experience representing companies, investors, and entrepreneurs in a wide range of high stakes business transactions.
Adam handles the small and large transactions in the life of a businesses, including mergers & acquisitions, entity formations, partnerships and joint ventures, investing and fundraising, commercial contracts, and dissolutions. His office can be reached at 212-859-5041.
Haley Kopp is a corporate lawyer focused on representing start-ups and small companies in formations, venture capital, angel investor financings, mergers and acquisitions, and general corporate matters.
Haley's diverse experience gives her a practical approach to solving complex business issues, whether guiding companies through financing rounds or corporate transactions. Her office can be reached at (619) 512-3652.
This guide is meant for educational and informational purposes only and should not be considered legal advice. It is essential to consult with an attorney or other advisors regarding all legal and other important matters.
