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Taxation of Grants and the Contribution to Capital Exception

As an early stage startup, companies are generally scrambling for funding and looking in any number of places to secure it. One key source of funding that is often overlooked is a grant. While grants come in various shapes and sizes, one of the most attractive aspects of many grants is that the granted funds need not be repaid, and the grantor does not acquire an equity stake in the startup. This allows an early stage startup to acquire funding for its business while not diluting the founders’ ownership stake. Grants come in all shapes and sizes, including public grants from state or federal government. While grants are often optimal sources of funding, most grants are still taxable income.

Section 61 of the Internal Revenue Code (“IRC”) defines gross income to mean “all income from whatever source derived.” As a result, generally speaking, grants are considered gross income and, like most gross income, grant money is taxable. This includes both government and private grants.

However, under certain circumstances, grants from government entities may be exempt from taxation. The most notable, and relevant exception is called the Contribution-to-Capital (“CtC”) exception. According to §118(a) of the IRC, a business need not include shareholder contributions to capital as gross income for tax purposes. Furthermore, under certain circumstances, contributions to capital from non-shareholders also qualify for the CtC exception. According to United States v. Chicago, Burlington & Quincy Railroad, 412 U.S. 401 (1973), in order to qualify for the CtC exception, the grant must have five characteristics: (1) the contribution must become a permanent part of the transferee’s working capital structure, (2) the grant money cannot be compensation for goods or services, (3) the contribution must be bargained for, (4) The contribution must foreseeably benefit the transferee in an amount commensurate with its value, and (5) the contribution must ordinarily be employed to generate additional income. In the case of a non-shareholder contribution to capital, the contribution must come from some governmental unit or civic group.

While § 118(a) sounds simple enough, it remains a source of considerable controversy and bares special consideration. First, and most obviously, the CtC exception only applies to corporate taxpayers, meaning LLCs are not eligible for the CtC exception. However, because the process of converting from an LLC to a C-Corp is generally quick and straightforward, an LLC may choose to convert to a C-Corp if it believes that the company has a relatively high probability of obtaining a CtC grant. Startups should balance the costs, both direct and indirect, of the conversion process with the potential money to be retained as a result of the CtC exception. For startups receiving only minimal grant money, the additional formality and structure of a corporation may not justify the small retention of money created through the CtC exception.

Next, the exception only applies when grant money is invested in real, depreciable capital. Therefore, startups that do not plan on using the windfalls of grant money on depreciable capital cannot avail themselves of the CtC exception. For example, many startups in the tech space often need to invest a great deal in hiring labor. However, using grant money to pay the salary of an employee or independent contractor would not be considered a contribution to capital and is therefore not eligible for the CtC exception.

Finally, startups should not make uninformed assumptions regarding whether the CtC exception applies to grant money received. The CtC exception is very narrow and the IRS has taken a decidedly stringent stance when deciding if the CtC exception applies, designating non-shareholder contributions to capital a Tier 1 examination issue. Startups should consult a tax-attorney or accountant when considering use of the CtC exception.

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Entity Selection for Startups: A Tax Perspective

The entity classification regulations under Internal Revenue Code section 7701, otherwise known as “check-the-box” regulations, allow startups to choose their classification for Federal tax purposes. Although the filing process itself is extremely simple (one simply checks the appropriate box, dates, signs, and submits the form), the tax implications of the choice of entity can be extremely significant.

This article will assist startups in choosing an entity by comparing and contrasting the tax implications of organizing as a C corporation, S corporation, or limited liability company (“LLC”). Sole proprietorships and partnerships will not be covered in this article as they do not provide full limited liability to owners, and other entities better meet the needs of most startups.

 

Startups that Expect Venture Capital Funding or Expect to do an IPO

The most significant tax feature of a C corporation is that it is taxed twice: first, the corporation is taxed on its net income, and then shareholders are taxed when they receive dividends. Though double taxation is unappealing, the first taxation layer prevents the corporation’s income from “flowing-through” to shareholders, which is why C corporations are the investment entity of choice for venture capital firms. Most venture capital firms raise money from tax-exempt entities, and if the firm invests money in a flow-through entity—such as an S corporation or LLC—then its tax-exempt investors would receive disadvantaged tax treatment.

If a startup plans on issuing shares through an initial public offering (“IPO”), then it should incorporate as a C corporation, as opposed to other corporate forms. An S corporation is unsuitable for an IPO because it cannot have more than 100 shareholders. LLCs are byproducts of state law, and thus it is extremely difficult to do an IPO of an LLC. Unlike a C corporation, which has unlimited life and free transferability, there is a risk that a LLC will dissolve when a member dies. Some states require all LLCs to dissolve after a set period of time. Furthermore, even if a LLC manages to become publicly traded, it will lose its status as a flow-through entity and lose it tax advantages.

In addition, if ownership interests in the startup will be provided to employees, tax law gives favorable tax treatment to incentive stock options (ISOs) granted by a corporation. An ISO holder does not have to pay taxes on the value of the stock options when she receives the options; the holder incurs tax liability only when the shares are sold. At the time of sale, the recognized gain is taxed at the long-term capital gains rate, which is more favorable than the ordinary income tax rate.

Thus, if the startup expects to receive funding from venture capital firms or do an IPO, then incorporating as a C corporation is the clear choice. However, choosing an entity becomes less straightforward in cases where venture capital funding or an IPO is not expected.

 

Startups that Expect to Initially Operate at a Loss or Distribute Current Earnings

As discussed above, S corporations and LLCs do not pay corporate tax because it passes income directly to its owners and investors. Because current earnings are taxed as ordinary income, startups intending to distribute current earnings and profits to their owners would avoid double taxation by organizing as a flow-through entity. On the other hand, if a startup expects to initially operate at a loss, then its owners will be able to deduct losses from their individual taxable income.

If a C corporation distributes current earnings, the amount cannot be deducted by the corporation except as salary (or other reasonable compensation) to shareholders who are also employees of the company. Thus, startups that expect to operate at a loss initially or to distribute current earnings should not incorporate as a C corporation. Instead, they should organize as a flow-through entity.

For startups that seek to build long-term value by accumulating or reinvesting earnings, other factors become more important. But in this case, since stock held for more than one year is taxed at the long-term capital gain rate—which is lower than the ordinary income rate—incorporating as a C corporation should be considered. Moreover, if a C corporation that qualifies as a small business corporation holds stock for more than 5 years, it will likely cut its capital gains tax rate in half.

As mentioned above, in certain cases there are tax benefits in organizing as a flow-through entity. Next, we will examine the implications of organizing as an S corporation versus an LLC.

 

Incorporating as an S Corporation vs. a LLC

As flow-through entities, S corporations and LLCs enjoy similar tax benefits. Neither pays corporate tax on earnings, and owners in both can deduct losses from individual tax returns. There are important differences, however, in ownership and formalities.

The IRS subjects S corporations to more restrictive ownership regulations than LLCs. First, S corporations can have no more than 100 shareholders, can only have one class of stock, and may not have non-U.S. citizens or residents as shareholders. Also, S corporations can only have one kind of shareholder: individuals. This limits startups that would otherwise consider raising capital from institutional investors. Comparatively, an LLC is unrestricted in the number of its members, can have foreign members, multiple classes of stock, and institutional investors as members. Therefore, LLCs are much less restricted in its ownership regulations. Additionally, LLCs can be incorporated tax-free for even more flexibility. For instance, after its owners and investors have deducted the initial startup losses, the LLC can incorporate in order to obtain funding from a venture capital fund.

Moreover, S corporations are corporations—which mean they must adopt bylaws, issue stock, hold initial and annual director and shareholder meetings, and keep meeting minutes with corporate records. LLCs, on the other hand, are not required to take any of these steps, although they are recommended.

Generally, because LLCs are flexible, require minimal formalities, and are easy to set up, any startup looking to establish itself as a flow-through entity should probably organize as an LLC,

 

Summary

Incorporating as a C corporation is recommended for startups that expect to receive venture capital funding or do an initial public offering. This explains the wide prevalence of C corporations on the West Coast, where venture capital funding is abundant. On the other hand, organizing as an LLC is recommended when startups expect to operate at a loss initially or distribute current earnings. Although S corporations are also flow-through entities, LLCs are generally better suited to startups because of the ownership restrictions and additional formation requirements for S corporations.