Which Entity is right for you? (Part 1)
C-Corp versus S-Corp
There are five main types of Business Structures: Sole Proprietorships, Partnerships, Limited Liability Companies, Corporations and Nonprofit Organizations. Generally speaking, most businesses must choose between the corporation and limited liability company structures, because these are legal entities that have separate legal existence and therefore protect their owners from liability.
In this first blog, I will give you the pros and cons of the C-corp and information on the S-Corp election, so that you can make a more informed decision. This explanation is by no means exhaustive, but should be a good base to start from.
Considerations
There are four issues you want to consider when choosing which entity type you want for your business:
- The type of members/owners and management styles available;
- The type of investment or capital requirements;
- The tax repercussions and statutory governance requirements associated with the entity; and
- The level of protection afforded to your personal property against liability.
The Corporation:
Governance
In a nutshell, the “corporation” or C-corp is a legal entity consisting of one or more owners. The entity is established by filing Articles of Organization with the state and fulfilling the corporate governance requirements, including establishing a Board of Directors, and authorizing and issuing shares. Most importantly is establishing a Shareholder Agreement and By-laws for the company.
The Shareholder Agreement lays out the rules, responsibilities, and obligations of each of the owners. For instance, what happens if an owner wants to sell? If someone dies, gets divorced, retires? Who gets to decide if the company is going to sell assets or bring on new investment? Most importantly what rights do the company and other shareholders have if an owner wants to sell their shares? The Shareholder Agreement is an operating manual for the company, so that no matter what curveballs business throws you, you have a mechanism for dealing with them fairly and effectively.
The Bylaws set out additional important (and statutorily required) information for the business, such as when you hold a shareholder or a director’s meeting and how you give notice to the shareholders. How do you elect officers?
While this may seem a little onerous, especially when you are just starting out, these documents and following their policies play a very important role in maintaining the corporate form and keeping up the liability shields between the owners and the entity.
All corporations have Shareholders (owners), directors, officers, and employees. These positions are established by the laws in the state where the corporation is incorporated and have the powers and rights provided for in those laws as well as the Bylaws.
A C-corp may have an unlimited number of Shareholders and may have multiple “classes” of shares, which means that each of the different classes created by the company have different voting and financial rights.
Taxation
The C-corp runs on a fiscal or calendar year as designated by the Board of Directors. C-corps are subject to “double taxation,” which means that the revenue of the company is taxed at the corporate level and at corporate rates, and then taxed again at individual rates when distributed to the shareholders. While generally dreaded, the double taxation structure allows a corporation to retain earnings (maintain a rainy day fund or cash on hand for budgetary expenses), without the tax liability for such funds being the responsibility of the owners. Additionally, the corporate tax rates are often lower than the individual tax rates. There are also some unique deductions that the c-corp benefits from. The C-corp can further provide deductible fringe benefits to employees, as a result of this structure.
The C-corp given its ability to provide multiple classes of shares with different rights, offer stock option plans, and “go public”, make it an attractive structure for large scale investments and tends to be favored by VCs.
S-Corp Election
An “S Corporation” is the same as the C-corp. It is formed the same way and has the same structure and governance requirements, but after forming, an S-election is filed with the IRS in order to change the tax treatment of the entity. This tax filing places some restrictions on the S-corp’s functioning, namely:
- An S-corp can only be formed by individuals (as opposed to another corporation or trust);
- All owners of an S-corp must be US citizens or permanent residents; and
- An S-corp may only have one class of shares (so no creativity with control and financial rights, everyone is treated the same).
The S-corp election must be filed within 75 days of incorporation and then must be re-filed every year in order to remain effective. The election will stay in place as long as the filings are made on time and none of the above three restrictions are violated. If for any reason they are, then the election is broken and the company will revert to a C-corp in terms of tax treatment and restrictions. Be careful when breaking the election. Once you do, you are restricted from pursuing S-corp status for five years.
So what does S-corp status do? It makes the corporation a pass through entity, so that there is no double taxation, but all revenues and losses pass through to the individual owners at their individual tax rates. This can be advantageous at the beginning, where you have long term plans for which the C-corp is the best structure, but in the meantime would benefit from pass-through losses and the less tax resulting from the lack of double taxation. Another benefit is that you can limit self employment tax if you are receiving a FMV salary from the business and the remaining profits are distributed as dividends. This scenario is pretty individualized though, so see your accountant!
Quick Breakdown of Pros and Cons
C Corporation
Advantages:
- Can have complex and creative ownership structures providing for divergences
in equity ownership of the corporation and operational control of the business, references to dividends or other payouts, different voting rights attributable to various classes of stock and Income splitting between owners.
- Provides deductible fringe benefits for shareholders/employees, such as group term life
insurance plans up to $50,000; Medical reimbursement programs; and 100% medical and
disability insurance premiums. Fringe Benefit possibilities are more available and flexible
than in an S Corp.
- Election of fiscal year.
- In some cases, corporate tax rates are lower than individual tax rates.
- Passive activity losses are deductible by C Corps under certain circumstances.
- The ability to deduct up to 80% of dividends received.
- The ability to use multiple Corporations.
- Can use an employee stock ownership plan
- Can go public.
- Qualified Shareholders may exclude 50% of capital gains from the sale of C Corporation
stock.
Disadvantages:
- Tax on corporate earnings applies at the Corporate level and then a second time when
Shareholders receive and report dividends.
- IRS audits can result in the creation of constructive dividends for what the IRS considers
personal use of corporate assets.
- C Corporations are subject to the Alternative Minimum Tax
- C Corporations may be subject to the personal holding company tax or the accumulated
earnings tax.
- The accrual method of accounting is generally required.
- C Corporations generally have less flexibility than other business entities.
S Corporation
Advantages:
- Income earned by an S Corporation is taxed only one time, at the Shareholder level.
- Corporate losses pass through to the S Corporation Shareholder and are deductible at the
Shareholder level.
- Passive S Corporation Shareholders can offset passive losses from other activities with their
S Corporate earnings.
- S Corporations are not subject to the accumulated earnings tax, alternative minimum tax, nor
the personal holding tax.
- Active S Corporation Shareholders are not subject to FICA tax on the S Corporation net
income.
- S Corporation Shareholders who materially participate and have incurred debt to acquire the
stock of the corporation are able to deduct the interest expense as business interest.
Disadvantages:
- Fiscal years must coincide with the calendar year, generally, limiting the opportunity to shift
income.
- Potentially higher tax rates on certain levels of taxable income.
- Fringe benefits received by Shareholders owning more than 2% of the corporation are
included in Shareholder income.
- Dissident or new Shareholders can cause the termination of the S election through a
disqualified transfer of stock.
- On formation, election must be filed timely (within 75 days) if to be in effect for the first
year of existence. Can be filed within 75 days of commencement of fiscal year for post
incorporation fiscal years but all stockholders must sign. Once election is revoked/lost, it
cannot be used again for 5 years.
- Not a good structure if stock options are to be used for employee incentives.
- S Corp cannot be a subsidiary of another Corporation.
