Corporate Tax

Analysis confuses enterprise capitalists’ assumptions about corporate tax incentives

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Venture-funded startups and their investors often lose taxes because they are organized as businesses rather than limited liability companies, a study by the University of California at Riverside found. ..

Reason? Venture Capitalists (VCs) are familiar with C companies, and Limited Liability Companies (LLCs) have significant tax benefits that outweigh the potentially high start-up costs, but in taxes. Doesn’t pay much attention. Investors in the companies included in the survey paid $ 43.9 billion more in taxes than they would have organized as LLCs instead.

Corresponding author Eric Allen, assistant professor of accounting at the University of California, Riverside, said, “It really shows that the tendency to stick to the standard options everyone else is using can lead even seasoned actors to make inefficient decisions meet.”

It’s all about loss.

When a company starts a business it has to choose an organizational structure to do business. For the majority of startups, C-Corporation and LLC are the only forms that offer desirable ownership attributes such as limited liability and stock-based incentive pay. The LLC’s increased tax savings are due to two dynamics. It is the tax treatment of different forms of organization and the fact that most start-ups lose money early and close without profitability.

This is a simple stylized example to help explain what this actually looks like. Let’s say you have a startup, LOSSCO, and you want to close it after losing $ 1,000. When organized as Legal Entity C, it is taxed as a separate entity. This means that tax incentives are only granted if the loss remains with the company and the company ultimately makes a profit. Tax incentives are not recognized at the company level because the company fails before it makes a profit. Business owners are entitled to tax credits as long-term capital losses on other capital gains. Due to special tax laws on capital gains, this can bring up to a profit of up to 20% or $ 200.

Alternatively, when LOSSCO is organized as an LLC, there are no corporate-level taxes. All profits and losses immediately flow to the owner for immediate taxation. In this case, it means that the company’s loss of $ 1,000 is immediately deducted from the owner’s other income. Assuming investors face a 35% tax rate, the $ 350 tax incentive is significantly higher than if they were organized as a legal entity.

Most industry participants are aware of the potential tax savings, but generally Higher Costs. Alternatively, the difficulties associated with filing an LLC tax return and other regulatory filings outweigh the profits. However, the amount of benefit has not yet been thoroughly investigated.

Allen and co-authors Jeffrey Allen of Bentley University, Sharat Ragavan of the University of California, Berkeley, and David H. Solomon of Boston University IPOs, or IPOs, are prospectuses of 1,155 VC-capped public companies that were made between 1997 and 2014 are noted. 98% of them were C companies. 92% of all companies reported a net operating loss shortly before going public. Most failed or were acquired with losses without access to tax savings.

The authors found that if the startup had been registered as an LLC, investors could have used the loss to completely eliminate taxes from the remaining 8% of profitable companies. .. The remaining loss can then be passed on to the shareholders and offset against other taxable income. VC-funded companies that did not go public had even higher potential tax savings.

By combining IPO and non-IPO patterns, the move to LLC resulted in an overall tax saving of $ 43.9 billion. That’s about 4.9% of your invested capital, or 3% of your estimated net income. The potential tax savings are far greater than some of the high costs and difficulties of becoming an LLC, which makes the criteria for incorporation even more inadequate.

Further research has shown that venture capitalists often encourage startups to reorganize as C companies. This “path dependency” allows inefficient forms to persist for long periods of time. This is due to its popularity, which reduces the implementation costs of each participant.

“The most surprising thing is not that some companies are V-corporations, but essentially everything. Most annoyingly, the current setup pays most of the cost. A taxable VC investor. “Allen said.” But they don’t seem to be pushing VC managers to make better demands. Start-up The structure, the industry only adheres to deep-seated practices. ”

This is how you preserve the company’s value in the event of a merger or takeover

For more informations:
Eric J. Allen et al. on the tax efficiency of start-ups SSRN E-Journal (2017). DOI: 10.2139 / ssrn.3069256

Provided by
University of California, Riverside

Quote: The survey was conducted among companies (August 11, 2021) and was accessed on August 11, 2021 from Confuses venture capitalists’ assumptions about tax incentives

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