C Corporation Taxation for Investors vs LLC and S Corp
C corporations pay taxes on their gross income minus all operating expenses. They then distribute profits to shareholders, and shareholders pay income tax on the dividends.
This means the shareholders, including investors and venture capitalists, only pay taxes on the money that is distributed (or paid) to them.
This is also known as "double-taxation," since the company’s revenue is taxed in two phases: (1) on the level of the business entity, and (2) on the level of the individual shareholder.
LLC Taxation and Venture Capital/Investors
LLCs members pay taxes on their share (as a percentage of ownership) on the LLC's profit regardless if they were paid a distribution or not.
It's very clear why an investor wouldn't want to pay taxes on money they don't receive. It's also difficult to transfer ownership of an LLC, so much so that investors wouldn't want to deal with it.
S Corp Taxation and Venture Capital/Investors
Venture capitalists prefer C corps over S corporations (S corps) because like an LLC, an S corp investor or VC would be required to pay taxes on the S corps profit even if they didn't receive a distribution.
S corporation taxation regulation also varies at the state level which makes accounting complex for investors.
C Corp Benefits for Investors and VCs
Unlike other business structures, C corporation shareholders only have to pay taxes when they receive dividends from the company.
In the case of an LLC, all owners pay tax on the annual earnings of the company, regardless of whether they receive a distribution or not. This is a major reason investors prefer C corps: they only need to worry about paying tax for the money they actually receive.
C corps are also better for investors and VCs due to the way that their taxes are filed with the IRS. When investors acquire partial ownership of an LLC, they have to wait to file their own personal taxes until they receive a K-1 form from the LLC. This can complicate the filing process for passive owners of the LLC.
The tax filing process for C corps is much more streamlined, which is another reason why they are the preferred entity choice for investors.
Simple Transfer Ownership
Investing in a C corporation means acquiring partial ownership of the company. Investors and VCs receive a certain number of shares, which entitle them to a percentage of profits.
LLCs, on the other hand, must revise their operating agreement in order to adjust ownership of the company to accommodate new investors. This process is a bit more complicated, so it is often easier to simply invest in C corps.
Natural Exit Strategy
When investors and VCs are ready to withdraw from a company, they need to have an exit strategy in place. A common strategy for exiting an investment in a company is to sell your ownership, whether that’s shares on a corporation or units of ownership in an LLC.
Selling ownership in an LLC is a fairly simple process: you can either find a buyer to take over your percentage of the company (with the permission of the rest of the owners), or you can relinquish your percentage to the current owner(s) for a defined sum. In either case, the money you receive from exiting that LLC is subject to significant government taxes.
Exiting a C corporation, on the other hand, is often a tax-free event. Due to the Qualified Small Business Stock exemption in Section 1202, investors who have held an investment in common or preferred stock for 5 or more years may be able to cash out without paying taxes on earnings up to $10,000,000.
This tax break for investors makes C corps particularly enticing to formal investors.