C-CORPORATION BASICS
Just like an "S-Corporation ," a "C-Corporation" (or a C-Corp), is a legal entity. While an S-Corporation (or an S-Corp) is taxed under Subchapter S (hence the name) of the Internal Revenue Code ("IRC"), the C-Corp is taxed under Subchapter C. This short article explains the key features of C-Corporations, how they are formed, what advantages they have (especially for some startups), some disadvantages they may have, and how they differ from S-Corporations and limited liability companies (LLC's).
If you are looking to form an corporation to run a new business or startup venture, or for an existing business in New York or in Los Angeles or Ventura County, California, I can help you determine whether a C-Corporation makes sense for your business and its goals, or help you transition from a sole proprietorship or another structure into an C-Corporation. I can also help you change the state of formation ("re-domicile") of a corporation, limited liability company or other business entity.
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Forming a C-Corp in California or New York
Formation & Organization
Forming a C-Corporation involves several key steps, which generally follow these steps (with some adaptations as may be legally allowed). First, a unique and appropriate name for the corporation must be chosen. Second, the Articles of Incorporation (also called a Certificate of Incorporation or Charter) are prepared and filed with the state authority, typically the Secretary of State's office, providing legally required information about the corporation and and including any other permissible provisions. Third, the incorporator holds an initial "Organization Meeting" (or adopts a written consent in lieu of a meeting), adopting bylaws, appointing initial directors, taking any other desirable and permissible actions, and, finally, resigning as incorporator. Fourth, the initial board of directors holds a meeting (or adopts a written consent in lieu of a meeting) to adopt and confirm the actions of the incorporator, elect officers, issue initial shares of capital stock, adopt a fiscal year end, and take other administrative matters and actions that is desired.
Post-Formation Actions
After these formation and initial organizational steps are take by the incorporator and the board of directors, if required for its business, the C-Corp will need to register to conduct business in a state other than where it was formed, and obtain permits, licenses, or certifications before it can begin its business operations. Additionally, an Employer Identification Number (EIN) must be obtained from the IRS for tax purposes. Registering for various state and local taxes is also necessary. Finally, as appropriate to the business, the corporation may need to adopt certain matters or enter certain post-formation agreements with its founders, such as restricted stock purchase agreements, notice of stock issuance, consulting or executive employment agreements, proprietary information & inventions assignment agreements , employee stock option plan, a shareholders' agreement, and/or any other agreement or contract that may be necessary or desirable.
Ongoing Requirements
Ongoing requirements include filing annual reports and other filings required where the company is formed and/or does business; holding board and shareholder meetings (or adopts written consents in lieu of meetings), maintaining corporate records, and fulfilling tax obligations.
C-Corporations vs. S-Corporations
Some entrepreneurs elect for their corporations to become S-Corporations, which is a corporation having a special tax status. This status can result in significant tax savings, but it also comes with important restrictions and conditions. (Note: unless all shareholders of the corporation specifically choose to be treated as an S-Corporation and file the appropriate form on time with the IRS, the corporation will, by default, be a C-Corporation.) There are other essential differences between C-Corps and S-Corps that you should know before selecting one over the other. This decision should be taken after consultation with your tax accountant and small business lawyer. These and other traits are discussed in further detail below, but in short, the following are generally the main differences.
- S-Corps do not pay federal income tax at the entity level, avoiding what is often called "double taxation." On the other hand, a C-Corp must not only file its own federal tax return, but it must pay federal income tax on its taxable income. When the left over profits are distributed to the owners, the owners have to pay federal income tax on those distributions (resulting in taxation two times on the same income—double taxation).
- While S-Corps cannot have more than 100 shareholders, there is no limit to the number of owners a C-Corp can have.
- S-Corporations must meet certain eligibility criteria—e.g., its shareholders must typically be either U.S. citizens or certain types of qualified trusts. C-Corporations can be owned by any human being and any kind of entity.
- S-Corps can only have one class of stock, while C-Corps have no limit on the number of classes of stock or series of stock within a single class.
Startup founders and other entrepreneurs should seek advice as to whether a C-Corp or S corp is better suited to their businesses.
Advantages of a C-Corp in New York or California
Many advantages flow from a C-Corp structure. Knowing them will help you understand if your business is best suited for this type of business entity. For a more detailed discussion of the corporations generally, read the article, A Bit About Corporations .
Limited Liability
As the corporation is a separate legal entity that can sue and be sued, own property and other assets, and take out loans, its shareholders' personal liability is limited to the amount of their investment. This protects their personal assets from any business debts or liabilities in the event the corporation files for bankruptcy or undergoes litigation.
Fundraising Potential
Unlike an S-corporation, a C-Corporations are generally unrestricted in the number and kinds of shareholders it has. This allows C-Corps to raise capital through, for example, private placements of stock and other securities to angel investors and venture capital firms, or with family and friends who are qualified investors and want to invest via their own business entities rather than in their individual capacity.
No Shareholder Restrictions
Unlike an S corporation, there are no limits on who can hold shares in a C-Corporation. For example, shareholders in a C-Corporation do not need to be US citizens. C-Corporation can also issue more than one class of stock, an attractive feature to potential investors.
No Capital Stock Restrictions
Unlike an S-Corporations, a C-Corporation can issue various types of capital stock, offering flexibility in structuring ownership and shareholder rights. C-Corps generally can issue two general categories of equity: common stock and preferred stock. Within each class, C-Corps can authorized and issue any number of series, such as standard common stock, non-voting common stock, and "alphabetized" series of common stock (e.g., Series A, B, C, etc.). Preferred stock, which has a greater claim on asset (liquidation) and dividend distributions, can also be authorized in any number of series, including Founders Preferred Stock, Series Seed Preferred Stock, and "alphabetized" series (e.g., Series A, B, C, etc.). each with terms that differ in one or more ways from the other series. C-Corps can further customize these classes by adding such features as convertibility (one class or series being convertible into another). The ability to create multiple classes and series of stock provides great versatility in tailoring ownership structures to meet specific business and shareholder requirements. S-Corps, on the other hand, are allowed only one class of capital stock, meaning that all shareholders must have the same relative rights and privileges in terms of voting power and distributions.
Disadvantages of a C-Corp in New York or California
While a C-Corporation offers many benefits, there are certain disadvantages when compared to other business entities. Some of these drawbacks primarily include double taxation, administrative and compliance requirements, and difficulties in converting to another entity structure in the future. Understanding these disadvantages is crucial for entrepreneurs and business owners in order to make informed decisions about the most suitable entity structure for their specific needs and goals.
Double Taxation
One of the primary drawbacks of a C-Corp is the potential for double taxation, as discussed in more detail elsewhere in this post. C-Corps are subject to corporate income tax on their profits. If dividends are distributed to shareholders, those dividends (which are part of the "leftovers" after the federal government taxed the profits the first time) are then taxed by the federal government again at the individual level. This can result in a higher overall tax burden compared to other business structures where profits pass through to the owners and are only taxed once at the individual level. On the other hand, for federal tax purposes, the profits of an S-Corp flow through to the individual owners and are tax only once at the tax rate of each owner. A similar effect occurs with an LLC. A multi-member Limited Liability Company (LLC) in the United States is generally treated as a partnership for federal tax purposes. By default, the IRS does not tax the LLC itself; instead, the income, losses, deductions, and credits of the LLC "pass through" to the individual members, and they report and pay taxes on their share of the LLC's profits or losses on their personal tax returns. A single-member Limited Liability Company (LLC) in the United States is treated as a "disregarded entity" for federal tax purposes by default. This means that the IRS does not consider the LLC to be a separate entity for tax purposes, and the owner reports and pays taxes on the LLC's income and expenses on their personal tax return.
Complex Administrative Requirements
Compared to LLC's, corporations have more complex administrative and compliance requirements (called "corporate formalilties"). They must maintain detailed corporate records, hold regular shareholder and director meetings, and comply with various reporting and filing obligations at the federal, state, and local levels. This can require additional time, resources, and costs for administrative tasks.
Conversion Difficulties
Converting a C-Corp to another business structure can be complex and may result in tax consequences. If the business needs to change its entity structure in the future, such as converting to an S-Corp or LLC, it may require significant effort, time, and professional assistance.
Increased Regulations and Oversight
C-Corporations require onerous recordkeeping and reporting obligations. Annual shareholder meetings must be conducted regularly, and minutes of these meetings must be recorded. Details of the division of ownership and the director's voting records must also be recorded. They also involve complicated tax arrangements.
May Be More Costly To Set Up and Run
Businesses are typically required to pay a filing fee when registering a C-Corp. They may also be required to pay additional annual state-based fees. Due to the complex regulatory environment C-Corps operate in, they typically engage attorneys and accountants to ensure compliance with federal and state laws.
Before deciding to incorporate, it's worth speaking to a corporate lawyer to understand the advantages and disadvantages relevant to your situation.
Considerations For Choosing A C-Corp
When deciding between a C-Corp and an S-Corp as the optimal legal structure for a new business, two crucial factors are the type of business or business, and the goals of the founders. The nature of the business itself and/or its anticipated needs (such as its industry, growth potential, reinvestment of profits, profit-sharing, and funding requirements) can play a significant role in determining whether a C-Corporation (C-Corp) or an S-Corporation (S-Corp) is more suitable. Additionally, the personal goals and aspirations of the founders, including their desire for profit distribution, tax preferences, can also weigh heavily on the choice between a C-Corp and an S-Corp. By carefully analyzing these two considerations, entrepreneurs can make an informed decision that aligns with both their business's characteristics and their personal objectives, setting the stage for a successful and sustainable venture. Founders or existing business owners should consider the following in deciding whether for form a new venture as a C-Corp or to convert an existing business from or to a C-Corporation structure.
Owners' Need for Cash Flow
Since the the income of a C-Corp is subject to being taxed twice (once to the corporation, and again after the post tax profits are distributed to the owners), if the owners intend to use the profits of the business for their personal needs, a C-Corporation would likely not be the right choice. Of course, everyone's situation is different, and the tax code and treasury regulations are a bewildering maze of confusing terms, complexities, and un-intuitive rules and regulations, so founders should speak to their own, independent tax advisors to determine what will work best for them.
High-Growth Startups
C-Corps are subject to separate taxation from the income that its owners receive from its operations. This allows businesses to retain all or a portion of its profits within the company rather than paying as dividends to the owners. Retained earnings can be reinvested in growth initiatives, research and development, near-term asset acquisition, or expanding operations. They can be set aside for capital accumulation over time, providing financial security and stability for lean times, or to have a "war chest" for future litigation, or to have a nest egg for taking advantage of future acquisitions or other opportunities without having to sell more stock or borrow money (or in the alternative, to increase its creditworthiness for future borrowing or its attractiveness to future investors), or for self insurance, or for other reasons. Retained earnings can also give the company greater flexibility in the timing of any dividends they may declare payable. C-Corps may have the ability to take advantage of lower tax rates on retained earnings that are reinvested back into the business. This can be beneficial for small businesses that intend to use the retained earnings for strategic investments or business development, as it allows them to defer taxes on those reinvested funds until they are eventually distributed as dividends.
Going Public
If a business has aspirations to go public in the future, a C-Corp structure is generally more suitable. The established corporate governance framework, ease of issuing publicly tradable shares, and familiarity of investors with C-Corps make it a favorable choice for companies aiming to enter the public market.
Complex vs. Simple Ownership Structure
C-Corps offer flexibility in ownership structure by allowing the issuance of different classes of stock with varying rights and privileges. This is advantageous when there are multiple investors or founders with different levels of ownership, voting power, or dividend preferences.
Subsidiary Companies
The Internal Revenue Service (IRS) regulations state that an S-Corp must have only "eligible shareholders," including individuals, certain estates, and certain types of trusts. This restriction, therefore, prevents an S-Corp from being a subsidiary of other business entity, such as other corporations or LLCs. Therefore, if a business intends to have a subsidiary structure or include other entities as owners, an S-Corp structure would not be suitable, and alternative entity structures, such as C-Corps or LLCs, should be considered.
Credibility and Perception
The established corporate structure of a C-Corp often (though not necessarily) conveys credibility and professionalism to investors, lenders, and partners. This can be advantageous for businesses aiming to build strong relationships and secure financing or partnerships.
Companies Wanting Flexible Profit-Sharing
A C-Corporation can provide flexibility in profit sharing through various mechanisms, although it may have certain limitations also. C-Corps have the flexibility to determine whether to pay dividends to its stockholders and, if so, can determine the amount and the timing of dividend payments. The alternative to paying dividends is to retain earnings in the corporation, reinvesting its profits back into the business to fund expansion, business and talent acquisitions, research and development, or other growth initiatives, which can benefit shareholders going forward by increased company value and potential future dividends. Corporations can also structure employee (both executive and non-executive) compensation packages to include bonuses, profit-sharing plans, or performance-based incentives. By linking compensation to company performance or profitability, C-Corps can provide a mechanism for sharing profits directly with employees or key executives. Stock Options and Equity Grants: C-Corps can offer stock options, restricted stock units (RSUs), or other forms of equity grants to employees, executives, or key stakeholders. These equity-based incentives provide an opportunity for individuals to participate in the company's financial success and share in the profits through stock appreciation or dividends when exercised or vested.
While C-Corps offer these mechanisms for profit sharing, it's important to consider the potential double taxation that applies to C-Corps. Profits distributed as dividends are subject to corporate income tax at the corporate level and individual dividend taxes at the shareholder level. This can impact the overall tax efficiency of profit sharing in a C-Corp compared to an S-Corp.
Consulting with legal, tax, and financial professionals is essential to assess the specific circumstances and goals of the business to determine the most appropriate profit-sharing strategies within the framework of a C-Corp.
TAKEAWAY
In conclusion, opting for a C-Corporation as the entity structure for a new business offers key advantages, including limited liability protection, flexibility in stock issuance, potential for employee stock option plans, separate taxation, and enhanced credibility. However, it is important to consider the drawbacks, such as double taxation, complex administrative requirements, potential limitations on decision-making authority, and difficulties in converting to another entity structure in the future. Entrepreneurs should carefully evaluate these drawbacks against the potential benefits before making a decision, ensuring they establish a strong foundation for growth, flexibility, and long-term success.
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