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1. Why is the C corp better for companies with a lot of proprietary IP?

2. Which way would you classify the typical software/web startup?

One of a typical web or software startup's most important assets is its product (which argues that they "have a lot of proprietary IP").

But they are also "asset-light cash business" in the sense that they don't have to have a ton of buildings or physical inventory like e.g. a manufacturing startup would, their physical footprint might consist entirely of one small leased office with a few computers.

I was given the advice I repeated above by an accountant a while ago. Admittedly, I don't recall the reasoning as clearly as I did when first told, but I think the basic idea is that it's more tax efficient to reinvest profits into a C corporation than a partnership or other pass-through entity.

Let's puzzle it out. C corporation math:

$1 revenue in let's assume a 50% operating margin, gross profit on $1 of revenue = $0.50 throw in another 10% for SG&A (sales, general, and administrative -- stuff your company does that isn't cost-accounted to production), we now have $0.40

Delaware has an 8.7% corporate income tax, reducing our $0.40 to 36.52 cents of free cash, which can be paid out to investors as a dividend or retained in the company for future growth.

If paid out, qualifying dividend tax would apply, leaving our investor with about 31 cents of profit. If kept in the company, shareholders would have 36.52 cents to reinvest.

Pass-through math: $1 revenue in Net profit: 0.40 (same as above)

Irrespective of whether profit is distributed or retained, and assuming a 28% individual marginal rate for partners, the partnership is left with 28.8 cents of post-tax profit that they can reinvest or distribute (take out for themselves). A few points from this example:

It's basically a wash tax-wise (28.8 cents vs. 31) if the profits are distributed. If profits are reinvested, the C corp has 36.5 cents of the original dollar left vs. 29-31, which will compound very significantly over time. So for a business that pays out most of its profits each year and doesn't reinvest (e.g. typical consulting company), it's likely better and simpler to use a partnership, whereas the C corp is better served for "asset heavy" companies with things that depreciate over time.

Software is tricky because even though it's an "asset" in every sense of the term ("probable future economic benefit", can be sold, etc.) most accounting systems don't recognize it as such. You should really get a CPA's advice on this, but I think the bottom line is, if you're going to (1) earn profit (most startups don't for a long time) and (2) reinvest a lot into the company, you're likely better off with a C corp, otherwise, for a cash business where most profits are paid out right away (law firm, ad agency, medical practice) you're better with a passthrough entity.

Hope this helps

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