Pass-Through vs. C-Corp for Biotech Startups: Tax Pros, Cons, and Investor Expectations
Biotech firms face unique challenges, especially at the startup stage. Heavily reliant on investment, it’s critical to choose the right corporate and tax structure from the outset, as making changes later on can be costly and complicated, and may impact your ability to attract investment and grant funding.
The two most common choices are C-corporations or pass-through entities, like LLCs or partnerships. Each has unique tax implications, operational, and fundraising concerns that can inform a startup’s trajectory.
So, in the interest of understanding the trade-offs and making the best possible decision for your startup, let’s discuss how these structural decisions can impact taxation and investor relations in both the short and long term.
But first, let’s drill down on the definitions.
Pass-Through vs. C-Corp: What’s the Difference?
A pass-through entity is one in which the company does not pay federal income tax. Instead, tax liability is passed on to the owners, who report income, gains, losses, and deductions on their personal returns.
Examples of pass-through entities include LLCs, partnerships, and S corporations.
Many early-stage biotech firms choose the LLC structure. The advantage is that the owners can claim early losses, which can significantly offset taxable income.
LLCs are also quite flexible and don’t have the same stringent reporting requirements as corporations. Where it gets complicated is when the company wants to start taking on investors or institutionalize investment; neither would be prudent or even possible with an LLC.
Pass-Through Pros and Cons
Perhaps the biggest advantage of a pass-through structure is that it allows the company to avoid corporate taxation. Owners are responsible for filing, paying, and all related documentation.
Additionally, biotech startups burn a lot of cash in the early stages. Those losses can be an advantage for high-net-worth owners or angel investors who can use losses to offset income in other areas.
Lastly, a pass-through structure is flexible regarding how profits, losses, and ownership rights are allocated. This may be advantageous, for example, when IP contributions vary between founders.
As the company matures and seeks outside investment, the advantages may become less apparent.
C-corporations
C-corporations pay their own federal taxes. Shareholders are taxed individually based on the distributions (dividends) they receive. Even though this is, essentially, double taxation, C-corporations are the most common entity for venture-backed biotech startups or any firm preparing for VC investment.
The C-corp structure is fairly straightforward, with a standardized format for stock issuance, capital raise structures, employee compensation, and board governance. It’s a structure that’s well-understood by the investment community, so it tends to simplify funding as the company matures.
C-Corp pros and cons
As the company grows, a C-Corp has strategic and tax benefits that an LLC cannot match.
Shareholders in a C-Corp may be eligible for qualified small business stock (QSBS) treatment, in which they may be able to exclude a substantial portion of capital gains when selling qualified shares held for five years or more. At exit, this translates to meaningful tax savings.
C-Corps can also retain earnings within the company to fund R&D, hiring, and business development before passing them on to shareholders.
For companies seeking equity funding, C-Corps offer a standardized structure that investors and VCs prefer. Conversely, with a pass-through entity, these activities would be challenging (or impossible) to execute.
What Biotech Investors Want to See
As mentioned previously, investors overwhelmingly favor C-corporations. Bear in mind, many VC organizations are legally unable to invest in companies with a pass-through structure, as the funds they manage (often pension funds, endowments, or tax-exempt organizations) may face severe complications if income or losses flow through.
Filing is much more complex for pass-through entities due to multi-state filings, unrelated taxable business income (UBTI), and other tax obligations.
As a result, biotech firms that start as LLCs often convert to C-Corps before engaging in any significant fundraising.
Governance and Operational Differences
LLCs are far more flexible and are typically governed by operating agreements customized to their unique needs. So, very good for founders at the outset, but not so great when seeking outside investment.
C-Corporations are more structured and follow a strict governance model that must include a board of directors, corporate officers, shareholders, voting rights, and standardized compliance and reporting. Though less flexible, this structure is more predictable for investors and other stakeholders who might join later.
Things to Consider at Exit
Generally, the C-corp structure is often more favorable at exit, especially if it involves an acquisition. In this scenario, the sale of stock can be advantageous to shareholders, as they can receive favorable capital gains treatment and (possibly) QSBS exclusions. Asset acquisitions may reduce those benefits.
Asset sales in an LLC context can sometimes be more favorable because capital gains are taxed only once. However, gains might be taxed as ordinary income or at higher self-employment tax rates if the entity is not treated as an S corporation. A sale of shares is often more favorable as it is taxed as a capital gain. If the business is being dissolved, keep in mind that all business debts must be settled and the closure reported to the IRS along with the final tax return.
Which Structure Should You Choose?
Ultimately, the ideal tax structure will depend on the company’s stage, funding strategy, and the type of investors you intend to pursue.
Choose a pass-through structure if:
The company is funded by a small group of angel investors or founders
You want to avail yourself of early-stage losses
You don’t expect to be dealing with venture capital
The company is primarily a research collaboration or project-based entity
Choose a C-corporation if:
You plan to pursue venture capital
You have institutional investors
You intend to grant equity incentives
Your plans include a large acquisition or IPO
Your choice of tax entity will have implications for taxes, governance, fundraising, and long-term growth. Working with an experienced tax advisor is the best way to ensure your interests are being served.
Speak to a Growise expert today, and let’s talk growth.