Every business owner has to choose at the outset what type of entity they want to create for their business. This choice has important effects on how the company is operated, how it is taxed, and the owner’s after-tax proceeds when the business is sold. This is the second in a series of posts about choice of entity. The first post covers S corporations.
C corporation characteristics
C corporations are regular business corporations, and they are the traditional entity choice for large companies. Before S corporations were created in 1958, C corporations were one of the only ways for business owners to have a liability shield. By “liability shield” I mean that the business’s owners aren’t held personally liable for the company’s obligations because the corporate entity acts as a barrier between the corporation’s operations and the company’s owners. See my post Piercing the Corporate Veil for more information about the liability shield.
Before they created the S corporation, Congress forced business owners to choose between having the benefits of a liability shield and having pass-through taxation. The choice was basically between corporations, which had the benefit of limited liability, and partnerships, which had the benefit of pass-through taxation.
What do we mean by pass-through taxation? Pass-through taxation means that a company’s owners are taxed directly on a business’s profits and the entity itself is not taxed. If a company doesn’t have the benefit of pass-through taxation, the entity is taxed on its profits, and the company’s owners are taxed on the same profits again when the profits are distributed from the company to the owners. This double level of tax can be pretty costly.
Here’s an example of how it works:
From this example you can see that the company’s profits are taxed twice by the time the money reaches the company’s owners. This is just a rough example, and it doesn’t take into consideration exemptions and lower dividend tax rates for lower income levels, but it does illustrate how double-taxation reduces the business owner’s after-tax income.
For comparison, let’s take a look at a pass-through tax example:
As you can see, the company’s income is only taxed once, which results in higher after-tax income to the business owner.
For the C corporation example, I applied a 21% tax rate on the business’s income and a 15% tax rate on the C corporation’s dividends, and for the pass-through example, I applied a 25% tax rate. However, the actual tax rates would vary depending on the company’s taxable income and the business owner’s tax bracket.
Thus, all things being equal, business owners would want to choose an entity that provides pass-through taxation. So why would a business owner choose to do business through a C corporation?
Benefits of C corporations
Many of the benefits of C corporations are enjoyed by high-growth startups what intend to raise money and allow their founders to exit by selling the stock in the public markets.
One of the benefits of C corporations is that they can raise money through traditional venture capital investments. When venture capital firms invest in companies, they generally do so through investment entities. As we discussed in Choice of Entity: S Corporations, S corporations can’t be owned by other entities, so S corporations (including limited liability companies that are taxed as S corporations) aren’t a good choice for companies that plan to raise money from the pros. For the same reason, S corporations can’t be taken public.
LLCs taxed as partnerships are a possibility for such companies, but partnerships that have operations in a lot of states are a burden on investors, who find themselves with tax compliance issues in each of these states, and partnerships can’t be taken public. Plus, investors don’t like the risk of having to pay taxes on income they don’t receive (which is a possibility with investments in S corporations and partnerships).
This leaves C corporations as the best choice for high-growth startups that will be seeking venture capital investments.
Another benefit of C corporations is that it’s easy to compensate employees with equity, which is another hallmark of high-growth startups. C corporations can issue stock options to employees as well as incentive stock options, which receive special tax treatment. Incentive stock options aren’t available to limited liability companies, and issuing equity to employees of LLC’s is more complicated.
Also, C corporations can issue qualified small business stock. These benefits aren’t available to S corporations or other types of business entities. Holders of qualified small business stock can sell their stock after it appreciates without having to pay tax on the gain. This can be a great benefit to people who invest time or money into high-growth startups in exchange for qualified small business stock.
Putting it all together
There are a number of benefits of C corporations, but most of these benefits are enjoyed more by high-growth startup companies than by regular mom and pop and main street businesses. So unless you’re planning to attract investment from venture capital firms, go public, or incentivize your employees through stock options, you’re probably better off organizing an S corporation or a limited liability company.