Greg Corombos: Hi, I'm Greg Corombos. Our guest in this edition of Expert Insights is Sandra Feldman, Publications Attorney at CT Corporation. One of the most important steps a new business can take is to establish a formal business entity. And knowing the differences in your entity options is critical in determining which one is right for your business.
Today, we're going to be looking at corporations and the pros and cons that go with that entity choice. Sandra will also explain the differences between a C corporation and an S corporation and how to evaluate those differences for your needs as well. And Sandra, it's always great to have you with us. Thanks for your time.
Sandra Feldman: Thank you, Greg. As you said, I'm going to talk about corporations. But specifically, I'm going to talk about the C corporation, which is one of the options business owners have in owning and operating their business.
The main options they have are the sole proprietorship if there's one owner, the general partnership if there's more than one owner, the C corporation, the S corporation, and the limited liability company or LLC. Now I'm going to explain what a C corporation is and compare and contrast that to those other options I just mentioned.
GC: All right, a lot to learn today. So let's get right into it. To begin, tell us what a C corporation is.
SF: Well, in order to understand what a C corporation is, you first have to understand what a corporation is. A corporation is generally defined as a business entity that's formed under the corporation statute of a single state. That definition is not really helpful. So a better way to understand what a corporation is, is to look at its main characteristics.
GC: And so what are the main characteristics of a corporation?
SF: There are five main characteristics that really define the corporation as a business entity.
First, a corporation has its own existence, separate and apart from its shareholders. Now, in many ways, a corporation is treated by the law like it’s a person. A corporation can enter into contracts, own property, sue, and be sued. It even has rights under the US Constitution.
And second, a corporation provides its shareholders with limited liability. The corporation is responsible for its own debts and liabilities. The shareholders are not responsible.
The third characteristic is that a corporation has perpetual duration. If one or even all of the shareholders die, sell their shares, or otherwise cease being shareholders, the corporation continues to exist as before.
The fourth characteristic is that a corporation has centralized management. Corporations are managed by or under the direction of a board of directors who are elected by the shareholders, but the shareholders do not manage. And fifth is that a corporation provides its shareholders with pre-transferability of interests. And that means that the shareholders can sell their shares to anyone they want, without there being any restrictions placed by the corporation law.
GC: Excellent to get all that background information on what a corporation is, and what distinguishes that. So now that we know that, what can you tell us about what a C corporation is?
SF: The C in C corporation refers to how the corporation is taxed for federal income tax purposes. And a corporation can be taxed in one of two ways. It can be taxed under Subchapter C of the Internal Revenue Code, which gives us the term C corporation, or it can be taxed under Subchapter S of the Internal Revenue Code, which gives us the term S corporation.
GC: So the C and the S when we talk about a C corp or an S corp really refers simply to how the corporation is taxed.
SF: That's right. The C and the S have nothing to do with the corporation as a business entity. So, C corporations and S corporations are not two different kinds of corporations. You know, you don't form a C corporation or an S corporation, you form a corporation. And when you fill out your articles of incorporation, nowhere does that form ask if it will be a C corporation or an S corporation.
And the corporation statute under which the corporation is formed and governed makes no distinction between C corporations and S corporations. So, the term C corporation really has a double meaning. First, it tells you that the type of business entity is a corporation. And second, it tells you that the corporation is paying its income taxes pursuant to subchapter C of the Internal Revenue Code.
GC: How does the C corporation pay income taxes?
SF: Well, a C corporation is a separate taxpaying entity, which to put it another way, a C corporation is a taxpayer as far as its own corporate income tax form. It pays taxes on its net income, just like you and me. However, it pays at the federal corporate income tax rate, which is currently 21%. When a corporation distributes its income to its shareholders in the form of a dividend, that's income to the shareholders, which they have to pay taxes on at their individual rate. So in a C corporation, the income that's distributed to shareholders is taxed twice, once to the corporation, and then again to the shareholders. And that's referred to as double taxation.
GC: Then what corporations get taxed as C corporations?
SF: Every corporation by default is taxed as a C corporation. And by default, I mean, if the corporation does nothing to change that fact, it will be taxed as a C corporation. And in fact, at one time, that wasn't the default way a corporation was taxed, it was the only way. But the owners of some corporations complained for years about double taxation and how it was making it difficult for them to survive. And finally, in 1958, Congress amended the tax law to add Subchapter S. Corporations that elect to be taxed under Subchapter S are referred to as S corporations.
GC: And the shorthand, of course, the C corp and the S corp, which we've already talked about. So now that we know that these distinctions exist within corporations in terms of tax purposes, what's the difference between the way an S corporation is taxed and the way a C corporation is taxed?
SF: An S corporation is not a separate taxpaying entity. It's what we call a pass-through entity for income tax purposes. And S corporations’ income passes through to its shareholders who pay income taxes on their share of the corporation's income at their individual income tax rate. So, with an S corporation, the corporation's net income is only taxed once, at the shareholder level.
GC: Can any corporation elect to be taxed as an S corporation, then?
SF: No, they can't. Subchapter S has a number of restrictions. For one, the corporation can have no more than 100 shareholders. And in general, they have to be individuals and US citizens or resident aliens. The corporation can also only have one class of stock, although voting rights can be different. Also, every shareholder has to agree to be taxed as an S corporation. And I should also point out that this is a voluntary election. Even if the corporation qualifies for S corporation taxation, the shareholders can still have the corporation be taxed as a C corporation.
GC: We're speaking with Sandra Feldman, Publications Attorney at CT Corporation. And, Sandra, now that we know what a C corporation is, let's discuss some of the advantages and disadvantages of a C corporation versus some of those other options you mentioned that business owners have. And so walk us through those comparisons if you can.
SF: Okay, well, let's start with the advantages and disadvantages of a C corporation versus a sole proprietorship or a general partnership. And the main advantage has nothing to do with whether it's taxed as a C corporation or an S corporation. It has to do with the fact it's a corporation. And a corporation provides its owners with limited liability. Sole proprietorships and general partnerships don't.
It can also be easier for a corporation to receive outside financing. Corporations can sell shares to the public. And in particular, corporations tax as C corporations can because they don't have those limitations on share ownership of Subchapter S. and incorporating can also add an element of credibility to the business.
GC: Sandra, what about the disadvantages, then?
SF: Well, the main disadvantage is that a corporation is more expensive to form and more complicated to operate. Corporations have to comply with the provisions of the governing Corporation statute, which means that they have to hold director and shareholder meetings, maintain a Registered Agent, file an annual report, maintain books and records, so forth. So proprietorships and general partnerships don't have that. And in the case of a C corporation, you have that double taxation of income.
GC: Yeah, I don't think too many of us have forgotten about that little distinction. What about the advantages and disadvantages of a C corporation versus an S corporation?
SF: As I mentioned, a C corporation and an S corporation are the same business entity. It's a corporation. So there's the same cost of formation and need to comply with the governing state corporation statute. So the differences between C corporations and S corporations have to do with tax law, not corporation law.
GC: What are the advantages then of being taxed as an S corp?
SF: The main advantage of an S corporation is a single level of taxation. Also, if the corporation has losses, they pass through to the shareholders who can use them to offset gains. Shareholders and S corporations can also get a 20% deduction on qualified business income, which shareholders in a C corporation are not entitled to.
GC: And then when weighing the S corp versus the C corp, what are the advantages of being taxed as a C corporation in that comparison?
SF: C corporations have an advantage in providing tax-deductible fringe benefits and retirement plans. Also, shareholders in C corporations only pay taxes on the income distributed to them. Whereas shareholders in S corporations have to pay taxes on their share of the corporation's income, whether it's distributed or not. And the current corporate income tax rate is much lower than the highest individual rates, which can soften the impact of double taxation.
GC: Alright, so then how do shareholders know if they should have their corporation taxed as a C corporation or an S corporation? How do they make that call?
SF: Those are complex. And I just mentioned a few of the differences between C corporation taxation and S corporation taxation. So my advice to shareholders would be to get the advice of a tax professional to get a complete picture of what the tax situation would be if the corporation is taxed as a C corporation or an S corporation.
And it's also important to remember the restrictions of Subchapter S. So, for example, if the shareholders plan on being publicly traded one day, or attracting investors by offering preferred stock, they should let the corporation be taxed as a C corporation.
GC: Sandra what are the advantages and disadvantages of a C corp versus an LLC?
SF: This one, you’re talking about a C corporation. You're not only talking about the corporation as an entity, but also about how it's taxed. I need to explain the differences and how corporations are treated under the federal income tax laws and how LLCs are treated.
GC: And what are those differences?
SF: Well, as we've discussed, the corporation can be taxed under Subchapter C or Subchapter S. However, there's really no such thing as being taxed as an LLC. Instead, an LLC takes on the tax status of one of those other types of business structures we've mentioned.
GC: Just want to make sure everybody's clear on this. Can you explain that a little bit further?
SF: Sure. Now, the owners of an LLC are called members. And by default, an LLC with one member is taxed by the IRS the same as a sole proprietorship. An LLC with more than one member is taxed the same as a partnership. However, any LLC can elect to be taxed the same as a C corporation. In fact, if the LLC qualifies, it can be taxed the same as an S corporation. So, in essence, an LLC can also be a C LLC or an S LLC. But for whatever reason, nobody refers to it in that way.
And I need to emphasize that regardless of how the LLC is classified for federal income tax purposes, where they’re paying taxes—like a sole proprietorship, partnership, or corporation—that has no effect on the LLC as a business entity. It always remains an LLC.
But to get back to your question about the advantages and disadvantages of a C corporation, specifically, versus an LLC, I think that because an LLC can be treated the same as a C corporation, we should probably ignore taxes right now and compare the corporation to the LLC as a business entity.
GC: Okay, I'll bite on that. How does a corporation compare to an LLC as a business entity?
SF: They actually have some characteristics in common. Both have been an existence separate and apart from their owners, and both provide their owners with limited liability. But other than that, they're really pretty different.
GC: And in what ways are they different?
SF: Well, one thing by default, LLCs are managed by all their members, rather than a centralized body, like a board of directors. Also, by default, members can’t sell their membership interests without the consent of the other members.
Now, those are the default rules of the LLC statute, but the members can opt out of them and their governing documents, but they’re default rules because it's assumed that's the way most members wanted.
An LLC is also a more flexible business entity. The members can share their financial management rights almost any way they want, as long as it's set forth in their operating agreement. In corporations, however, the shareholders rights depend upon how many shares they own. An LLC can also be managed more formally. The LLC statutes don't have the same mandatory provisions regarding governance as corporation statutes do.
GC: So Sandra, when should business owners choose a C corporation? And when should they choose an LLC that's taxed like a C corporation?
SF: There's no one right answer to that question. If the business owners know they want their entity to be taxed under Subchapter C, whether they choose a corporation or an LLC will mainly depend on what the owners want out of their business. For example, business owners who plan on an IPO or want to attract venture capital will usually choose a corporation. However, there are business owners who like the fact that the LLC statutes are less restrictive. So it really depends.
GC: Sandra, a lot of good thoughts on what corporations are, C corps versus S corps, how they compare to other entity options. So, any closing thoughts to help folks understand this even better?
SF: As a way of summarizing, when someone is deciding if they want to own and operate their business as a C corporation, they're really discussing two separate issues. One is whether they want a corporation as their business entity. And the second is whether they want that business entity to be a separate taxpaying entity under subchapter C of the Internal Revenue Code or a pass-through tax entity under Subchapter S. And both are vital decisions for every business owner. And what's right depends upon many factors, which is why I always recommend getting both legal and tax advice to help make the right decision.
GC: And finally, Sandra, how can CT Corporation help the business owners navigate this decision?
SF: Well, regardless of the decision, we can help both with the formation and with the post-compliance requirements, providing registered agents, helping file annual reports, and whatever else. The company will need post-compliance to make sure it stays in good standing.
GC: Excellent. Great advice all the way through and then assistance once that decision has been made to make sure the business remains in compliance, which is also critical. Sandra, thanks very much for your time today. We always appreciate it.
SF: Thank you, Greg.
GC: Sandra Feldman is Publications Attorney at CT Corporation. I'm Greg Corombos reporting for Expert Insights. For more information on this subject, please call CT at 844-787-7782