Choosing a Structure

One of the first considerations in examining a corporation as a structure for your business enterprise is the determination of your short and long term goals and the type of business you perform.

CHOOSING

• It is easier to form a C corporation than an S corporation or an LLC. (Simpler is not always but frequently better.) (For an example of what can go wrong with an S corporation election, see Rev. Proc. 2004-35.)
• You can issue qualified small business stock and potentially qualify for the qualified small business stock benefit under Section 1202 of the Internal Revenue Code and the rollover benefit under Section 1045 of the Internal Revenue Code [For investments in C corporations that are qualified small businesses under Section 1202 of the IRC before the end of 2011, the tax rate after holding the stock for 5 years is Zero--including a complete AMT exemption (subject to a cap (but a substantial one)).]
• You avoid having to issue your owners Forms K-1, subjecting them to federal income tax on the entity’s income (regardless of whether that income is distributed to them), and potentially subjecting them to state income taxes in the various states in which the entity has income tax nexus.
• You avoid having to agree to a cash distribution scheme to cover the taxes of the owners on the entity’s income taxed to them.
• It is easier for a C corporation to engage in an equity or debt financing.
• Venture capitalists typically won’t invest in LLCs and can’t invest in S corporations.
• Only C corporations can go public (generally).
• Equity compensation in a C corporation is easier.
• C corporations can participate in tax-free reorganizations under the Internal Revenue Code. LLCs taxed as partnerships cannot. What this means is this–if you are operating as an LLC and are offered to be bought out by another company for stock, your receipt of that stock will be taxable to you–even if the stock is not salable and can’t be sold to generate cash to pay the tax. With corporations, it is possible to be bought out for stock on a tax-deferred basis, and not pay tax on the stock received until you sell it. This is an important exit strategy consideration.
• There are potential self employment tax savings over what would be possible with an LLC.
• There is no limit on the type or number of shareholders that you can have.
• The dreaded “double tax” that everyone is afraid of with C corporations rarely ever occurs (there are, of course, exceptions–the cash cow business being one). Most positive exits are 1 layer of tax events–either stock sales or mergers structured so that there is only 1 layer of tax–at the shareholder level.
• Although losses cannot be deducted by the shareholders of a C corporation, losses frequently cannot be deducted by non-active members of the company in any event–so the loss pass through benefit to passive investors is frequently in fact not very helpful.
• The actual tax benefit of the pass through of any losses may turn out to be substantially less than expected.
• The tax accounting complexities associated with maintaining capital accounts in accordance with the Treasury Regulations make LLCs expensive for companies that desire to raise multiple rounds of financing.
• LLCs may have to remit tax payments to the IRS on allocations to foreign owners. See IRC Code Section 1446.

TYPICAL USES

• Less risk from government audits, compared to a sole proprietor
• Limited personal liability for business debts
• Deduct the cost of benefits as a business expense
• Split corporate profit among owners and the corporation for a possible lower overall tax rate
• No limit to the number of shareholders
• Can raise additional funds through the sale of stock
• Shareholders need not be U.S. citizens or permanent residents
• Limited liability protection. Owners are not typically responsible for business debts and liabilities.
• Unlimited owners. C corps can have an unlimited number of shareholders.
• Easy transfer of ownership. Ownership is easily transferable through the sale of stock.
• Unlimited life. When a corporation’s owner incurs a disabling illness or dies, the corporation does not cease to exist.
• Raise capital more easily. Additional capital can be raised by selling shares of stock.
• Credibility. Corporations may be perceived as a more professional/legitimate entity than a sole proprietorship or general partnership.
• Lower audit risk. Generally C corporations are audited less frequently than sole proprietorships.
• Tax deductible expenses. Business expenses may be tax-deductible.
• Self-employment tax savings. A C corporation can offer self-employment tax savings, since owners who work for the business are classified as employees.

TAX COMPLIANCE

C corporations are taxable at the entity level on their income. Thus, income earned by a C corporation is subject to double taxation: once as corporate income earned by the entity, and a second time, as capital gains or dividend income when realized by the shareholder. A C corporation cannot distribute its assets without recognizing income on the appreciation in those assets. It also cannot liquidate tax-free.

Therefore, while transfers to a C corporation can generally be structured to be tax-free, it is hard to transfer assets out of C corporations without paying tax. C corporations can participate in tax-free reorganizations with other C corporations. However, a sale of assets of the C corporation will be subject to double taxation. If the shareholders sell stock of the C corporation, there will be only a single level of tax; however, the 2 purchaser will take a carryover basis in the C corporation's assets and thus will not be able to amortize the purchase price in computing taxable income.

Under the Internal Revenue Code, most publicly traded entities are required to be taxed as C corporations. Thus, public companies have no choice but to be subject to the C corporation rules. With respect to smaller companies, the decision to become a C corporation should be given serious thought because it is hard to reverse.