In 2007 I co-founded Yashi with my then girlfriend and now wife Caitlin. The first decision we had to make was whether to incorporate as an LLC or a C-Corporation.
We did not seek any advice from our accountant or attorney on which type of entity we should incorporate our business as. Rather, I did my research on this topic by Googling and reading blogs. I read that venture capitalists don’t invest in LLC’s and LLC’s generally don’t go public.
We were super confident that every venture capitalist would eventually want to invest in our company, and we would eventually go public after our meteoric growth. So we incorporated Yashi as a C-Corporation in the state of Delaware.
In our first year of business we generated $750,000 in sales with no employees and no investors. We were profitable with a 50% gross profit and my wife and I made a couple hundred grand in personal income.
Woot! IPO here we come.
At the end of that year, we hired a local accountant that did my uncle’s businesses taxes. The accountant asked us why we didn’t incorporate the business as an LLC. I dismissed his questioning. I mean, who is this yokel local accountant asking me why I’m a C-Corp vs. an LLC. He doesn’t realize how big I’ll be someday. I’m the next Google, baby. Google’s not an LLC. What does he know?
In 2009, we doubled our revenues to $1.5 million. My wife and I made another few hundred grand in personal income that year. I was more confident than ever that I made the right decision to incorporate as a C-Corporation. I still believed that we would eventually raise venture capital and go public someday!
In early 2010, my accountant begins doing our 2009 taxes. He once again questions why we didn’t incorporate the business as an LLC. He then recommends that we convert Yashi to an LLC, but I still wasn’t listening to him.
By mid 2010, our revenue run rate for the year was trending to double sales again. However, no VC’s were knocking down our doors, and I was beginning to think going public may not be in our future. So if we’re not going to raise venture capital, and its unlikely we’d go public someday, maybe its not such a bad idea to convert to an LLC.
Depressed and humbled, I finally caved and filed the paperwork to convert Yashi from a C-Corporation to an LLC for the tax benefits my accountant kept telling me about.
Interestingly, at the end of 2010 we raised a $250,000 angel investment from a Wall Street hedge fund banker. He suggested that we get our financials audited in the event that we raise venture capital or sell the business in the future.
In mid 2011, we hired a regional accounting firm to perform our first financial audit. Prior to signing an engagement letter with the new accounting firm, they asked to review our prior tax returns.
After completing their review, they scheduled a visit to come into our office and discuss their fees and the estimated time to complete the audit. The first question they asked was why we converted our business from a C-Corp to an LLC.
While I thought it was obvious, I explained the tax benefits of being an LLC vs. a C-Corporation.
The next question they asked was if we paid our “built-in gain” tax associated with the conversion, because they didn’t see that line item on our tax return.
“What’s a ‘built-in tax’?”, I replied.
Bam! I was about to get hit by a mac truck.
They then explained that when you convert a C-Corp to an LLC, you have to pay the IRS a tax. The tax is based on the value of your business at the time you convert the business. The IRS essentially views the conversion of the C-Corp as a liquidation to the shareholders based on the value of the business at that time.
The answer was no, no we didn’t pay a “built-in gain” tax to the IRS. I then asked them how much the estimated “built-in gain tax” would be?
They explained that we needed to get a valuation performed by a third party company, but based on the fact that Yashi did just over $3 million in sales in 2010, and had estimated growth in 2011 to double again, that the value of our business could be as low as $3 million or as high as $6 million or more. They then explained that the valuation is subjective and the IRS can contest any third party valuation that we have performed.
Finally, they explained that based on the corporate and personal tax rates and those ball park valuation figures, we owe over $1 million to the IRS.
Wow, so I just bounced back from the bankruptcy of my last startup in 2007, and now three years later I built another profitable multi-million dollar business, and I’m about to file another bankruptcy. I can’t catch a break.
So I asked them how we proceed with filing bankruptcy.
That’s when they explained that, unfortunately, I cannot bankrupt a tax bill. This would be a debt that must be paid back either immediately, or over time. They also explained that I’m personally liable for the tax bill if the Company cannot pay it.
Here’s where it gets good. They finally explained that if I cannot pay the tax, I could face jail time for tax evasion.
Wow. What is going on here? Something didn’t seem right about this scenario.
The IRS was demanding that I pay a tax from the proceeds of the value of a business that I haven’t sold.
All I did was file a document with the state at the advice of a third party accounting firm, and now I may go to jail?
You may be thinking, just sue the accountant. Well, apparently when you file your tax returns and sign off on them, ultimately you, and only you are accountable. Your tax preparer is not responsible. At least that’s what our very expensive legal counsel explained to me.
So let’s recap. I hired a third party tax expert to advise me, and he’s not responsible for his advice? Again, something didn’t seem right.
I asked the new accounting firm if there was another way to prevent jail time. They explained that they can file a Private Letter Ruling with the IRS. The Private Letter Ruling would request the IRS to review our case, and to reverse our business back to a C-Corp from an LLC, as if it never happened. We then have to amended our prior tax returns to reflect these changes.
However, they told me to keep in mind that with a Private Letter Ruling, the IRS is essentially the judge and jury. They would review our case independently. In their sole discretion, they can reverse it as if it never happened.
I asked our accountants, “How likely is it that we would receive a favorable ruling?” They couldn’t provide any reassurances, because by nature, Private Letter Rulings are private, with very little case law to review, and this particular case has rarely occurred.
We filed the Private Letter Ruling.
In the meantime, my wife and I were expecting our first child. Talk about stress. At this point we also had a team of employees and an investor. We had to put a smile on our face as if nothing was wrong, and we had to keep growing the business. We had to stuff this deep down and bury it as if it wasn’t happening.
We kept growing the business. We grew the sales another 100% that year. Less than a year later, we finally got a ruling from the IRS.
We caught a break. The IRS ruled in our favor and allowed us to reverse the conversion as if it never happened, and I avoided paying the IRS one million dollars and jail time.
You may be wondering at this point why I even want to be an entrepreneur. That’s a long story, but the short answer is, I just want to make my mom proud. Although I do realize that going to jail probably wouldn’t have made her very proud.
We continued to grow Yashi’s sales 64% CAGR since we founded the business in 2007. In 2013, our sales exceeded $14 million. We have paid a lot of taxes over the last six years, both personal and corporate. I’m happy paying taxes now. I’m happier not going to jail!