Organizational Form Choices for Venture Capital-Backed Startups: Making C-Corporations Great Again?

Abstract

Venture capital (VC) funds are sophisticated asset managers that focus on generating returns for investors. Despite this fact, extensive research concludes that VC funds use a tax-inefficient organizational form for their investments (i.e., startups), incurring a tax cost of about 5% of funds’ invested capital. Using a model that more fully incorporates VC fund taxation, we find the opposite result: analyzing the same data as prior research, we find that VC funds save about 8% of invested capital by using their startups’ current organizational form versus the alternative. However, this advantage is not borne equally by investors, including fund managers who face additional tax costs under the current organizational form. We also find that the Tax Cuts and Jobs Act of 2017 reduces the tax advantage of VC-backed startups’ current organizational form. Our model informs VC fund managers evaluating organizational form choice and policymakers considering potential outcomes of tax changes.

Keywords: Venture Capital, Investor Taxes, Startups, Organizational Form, Pass Throughs, Partnerships, C Corporations, TCJA

JEL Classification: G23, G24, G32, H24