What Are Legal Business Entities?
When you were a child, you probably got by with just setting up a lemonade stand and getting right down to business. As an adult, starting a company isn’t quite as simple and one of your first decisions will be how to structure your business. While a C corporation will probably be your best bet if you are forming a high growth, finance intensive start up, there are seven primary business structures you generally should consider – each has its own advantages and disadvantages. In this article, we will cover the advantages and disadvantages of C corporations compared to S corporations. Before starting a business it is extremely advantageous to consult with a qualified business attorney in your city or state.
A C corporation (C-corp) is probably the most common business structure in the United States and has been around much longer than the others on this list. Larger companies usually favor this structure and, if you are a looking to build a Silicon Valley tech startup which raises venture capital, you should really consider a Delaware C corporation. Click here to read more about why you should incorporate in Delaware.
Advantages of C Corporations
Most venture capital firms prefer to invest in C corporations because:
- IRS Code Section 1202. One of the primary reasons that venture capital companies prefer C-Corps is the potential tax advantages of Section 1202 of the IRS code that allows up to $50 million of gain on the sale of a C-Corp to be federally income free. The analysis is more involved than can be explained here, but it is only available to C-Corps.Large amounts of stock can be issued along with stock options to employees.
- Legal precedence. C corporations have been around so long that the legal issues surrounding them are well defined. LLCs and other partnership entities are very flexible, but the legal outcomes of disputes between the owners, directors and officers are less predictable.
- Income taxes can be lower. C-Corps can be more income tax efficient than pass through entities like LLCs and S-Corps. Corporate tax rates are lower than personal tax rates. If the intention is to keep all the earnings in the business until you sell it versus distributing the earnings to the owners, then a C-Corp is the best income tax choice.
- Public companies are C-Corps. Having potentially millions of owners makes having a pass through tax entity impractical. A C-Corp is only taxed at the entity level, pass through entities are taxed at the owner level, and the tax responsibilities are borne by the owners.
- Less administratively cumbersome. All pass through entities have to go through the process of allocating the earnings to the owners and sending them a K1 which obligates the owner to pay the income tax. That process can create some administrative headaches.
- Limited liability. Owners are not liable for the Company’s debts.
Disadvantages of C Corporations
Conversely, some of the disadvantages of a C corporation include:
- Subject to double taxation. C corporations are taxed on the corporate level and then shareholders are personally taxed if the Company issue dividends.
- More administrative requirements. C-Corps have a more administrative requirements such as holding a yearly shareholder meetings, election of board of directors, formal written resolutions of the Board that document corporate actions on certain types of activities among other things that are not required with a LLC. Failure to comply with these requirements can result in the owners losing the corporate liability protection from the debt’s of the corporation.
- No deduction of business losses. You cannot deduct business losses on your personal taxes like you can with pass through entities.
An S corporation is simply a tax election that corporations and LLCs can make to be taxed under Subchapter S of the IRS tax code that eliminates the double taxation problem inherent with C-Corps. In order to take advantage of this tax election, the code requires the entities to meet certain requirements. To make sure your understanding all the tax and legal implications of an S Corp you may want to hire a lawyer online through sites like UpCounsel.
Advantages of S Corporations
Some of the advantages of S corporations include:
- Save on self-employment taxes. Owners can often times reduce their self-employment taxes which is a benefit only given to owners of entities taxed under Subchapter S. Self-employment taxes are over 16% of your taxable income that is paid in addition to income tax. This tax benefit is often times the reason that S-Corp status is chosen.
- No double taxation. Profits and losses are passed to the shareholders without it first being taxed at the corporate level. With C-Corps, the corporation pays tax on the income and then if the earnings are distributed to the owners as dividends, the owners pay tax on the same earnings, hence the phrase “double taxation of income.”
- Limited liability. Owners are not liable for the company’s debts.
- Conversion simplicity. S-Corp status can be easily converted to C-Corp status if necessary.
Disadvantages of S-Corp Status
However, venture capital firms generally don’t like S corporations because:
- Limited to 100 shareholders. S corporations are limited to 100 shareholders – which can make it difficult to raise capital.
- Only single class of stock. Venture capital firms generally want preferred stock which is not available with an S corporation.
- Certain types of owners excluded. S-Corps can only be owned by US Citizens and Resident Aliens. This excludes business entities and foreigners from being owners.
- Income and loss allocation difficulty. Income and loss cannot be allocated as easily because there is only one stock class and S-Corps do not permit special allocations of income and loss like an LLC does.
- Must Comply with corporate formalities. The owners must comply with the corporate formalities like annual meetings, board resolutions, etc or risk losing the protection against the liabilities of the corporations