When you’re in business, you may choose to operate as a corporation instead of an LLC. Whether you’ve already incorporated or you’re just getting started, it helps to know some fundamentals.
You may have heard that there are C corporations and S corporations. The “C” and the “S” refer to subchapters of the Internal Revenue Code. And the difference between a C corporation and an S corporation is how they are taxed for federal income tax purposes. A C corporation is taxed under Subchapter C of the Code. This is the default rule. Every corporation is a C corporation unless it elects to be taxed under Subchapter S by filing an election form with the Internal Revenue Service. The state corporation laws make no distinction between C and S corporations. It is a tax distinction only.
A C corporation (C corp) is a separate entity — it can own its own property, enter into contracts, sue or be sued in court, and lend or invest money. The entity is created once you incorporate in a state. Like other business entities, corporations are required, in most states, to file annual reports and pay franchise taxes. The business owners of a C corporation are called shareholders. (In some states they are referred to as stockholders.)
What are the main advantages and disadvantages of a C corporation?
C corporation advantages
- Separate legal identity
- Limited liability for the owners
- Perpetual existence
- Free transferability of shares
- Attractive to investors
C corporation disadvantages
- Expensive to form compared to other business structures
- Complex to operate
- Double taxation
For more information, see C corporation advantages and disadvantages.
Corporate ownership and management: Who’s who?
Corporations are owned by shareholders (or stockholders) and managed by directors and officers. A corporation could have hundreds or thousands of shareholders.
CT observation: Forming a corporation may be a good choice if you eventually want an IPO (initial public offering). Also, many venture capitalists, angels, and other investors prefer a corporation over an LLC.
A corporation’s board of directors is elected by shareholders and is responsible for overseeing corporate business and affairs. Corporate officers carry out the day-to-day management of the corporation.
Corporate bylaws contain the basic rules for conducting the corporation’s business and affairs. They typically cover things like directors’ committees, shareholders’ and directors’ meeting formalities (e.g., date, place, and notice), office location, and the powers, duties, and qualifications of directors and officers.
CT observation: In a closely held corporation with a handful of shareholders, individual business owner(s) typically wear many “hats” at one time: shareholder, officer, and director. Also, even though stock is “technically” freely transferable, closely held shareholders typically enter into buy-sell agreements or other agreements.
How do I form my corporation?
The process of incorporation involves selecting and reserving the corporation’s name, designating your registered agent, delivering your Articles of Incorporation to the corporation filing office of your chosen state of incorporation, and paying the state’s fee. A corporation’s existence begins when the state files the articles.
Each state has its own rules on what it asks for in the Articles of Incorporation. Typically, Articles of Incorporation contain:
- Corporation’s name
- Number of authorized shares (per class of shares and with a description of rights)
- Corporation’s registered agent and registered office
- Names and addresses of incorporators
Some states may also ask for the corporation’s purpose (e.g., a general purpose like “any lawful business”) and for names of initial directors. Optional items in the Articles of Incorporation include provisions regarding management and the rights, powers, and authority of directors and shareholders.
After the Articles of Incorporation are filed, an organizational meeting is held to complete the organization of the corporation. Often, a “paper meeting” is held and a signed statement of the action taken is filed in the corporation’s minutes book. At the organizational meeting, among other actions, directors are elected (unless they were already named in the articles), bylaws are adopted, and shares are issued.
What’s the difference between an S corp and a C corp?
The difference between an S corporation and a C corporation has to do with how they are taxed for federal income tax purposes. It also has to do with certain restrictions the Internal Revenue Code places on S corporations that C corporations do not have to deal with.
A C corporation is taxed as an entity. The corporation files its own income tax return and pays taxes on its profits at the corporate income tax rate.
An S corporation, on the other hand, does not pay taxes on its income. Its income, losses, and other tax items pass through to its shareholders. The shareholders pay taxes on their share of the corporation’s income on their personal income tax return at their personal income tax rate. The S corporation files an information return with the IRS.
Not every corporation can be taxed as an S corporation. Subchapter S contains restrictions on the number of shareholders (currently no more than 100), the kind of shareholders (in general they must be individuals and United States residents), and the classes of shares (no preferred stock allowed).
CT observation: State tax rules and federal IRS rules may differ. Even though a good number of states recognize federal S corporation tax status, some don’t. Also, a state may have its own election rules. This should also be addressed when talking with your advisor.
If you’d prefer pass-through taxation, or you’d like more information on S Corps, see our S Corporation discussion.
How are profits handled with a C corp?
Shareholders have the right to receive transfers of money and other property from the corporation in respect of their shares. These transfers are called distributions. When the corporation distributes its profits to its shareholders, this is known as a dividend.
Dividends may be received in cash, property, or shares. The board of directors decides, at its discretion, if and when a dividend will be declared.
However, by law, the board may not declare a dividend if such a declaration would leave the corporation insolvent. Some states further restrict dividends by providing that they can only be paid out of certain corporate accounts.
A corporation may grant particular classes or series of shares a priority in receiving dividends by so providing in its Articles of Incorporation. (This is one of the advantages of a C corporation over an S corporation. In order to be eligible for taxation as an S corporation, the corporation cannot have a class of shares with a preferential right to dividends or distributions.)
How are C corporations taxed for federal income tax purposes?
As we noted, C corporations are separate taxpayers for federal income tax purposes. A C corp files its own federal income tax return and pays its own income taxes (similar to an individual). If the corporation issues a dividend to its shareholders, the dividend is income for the shareholder. It must be included in the shareholder’s personal income tax return and taxes paid on the amount received.
Because of this, C corporations are widely known for “double-taxation”. The C corp pays tax on its income. And then the shareholders pay taxes on the income they receive in the form of a dividend. This means that the income is taxed twice: once to the C corporation and a second time to the shareholder.
Although C corporation taxation is generally thought of as a disadvantage, this is not always the case. For example, when the corporate tax rate is lower than the personal tax rate, pass-through taxation may not be such a big advantage.
Also, a less widely known tax aspect of C corporations is that with the proper planning, owners could avoid, or significantly lessen, double-taxation by using other tax-savings strategies available to C corps. For example, owners may be able to keep earnings in the business for reasonable purposes (instead of distributing any taxable dividends).
C corp owners might be able to achieve a lower tax bill with a combination of salary-and-distributions and a reduced (or no) taxable gain on the sale of certain qualifying stock. For a qualifying business, the favorable Internal Revenue Code Section 1202 gain reduction (or in some cases, exclusion) available to C corporations could be highly beneficial come tax time.
Can a C corp own an LLC?
The owners of an LLC, called members, can be individual(s) or entities — such as a C corporation. Neither the state corporation laws nor the state LLC laws prevent a corporation from owning an interest in an LLC or having LLCs as wholly owned subsidiaries.
How is a benefit corporation different?
A benefit corporation allows a company to benefit society while earning a profit.
A benefit corporation differs from a traditional for-profit corporation in three main areas: corporate purposes, director duties, and annual reporting. All benefit corporations have as a purpose providing a general benefit to society. They can have specific benefit purposes too. In addition, in a traditional for-profit corporation the directors have a duty to maximize the profits for the corporation’s shareholders. If they put the interests of non-shareholder stakeholders over the interests of the shareholders they may be considered in breach of their duties and subject to suit.
However, in a benefit corporation, the directors, in making decisions, are required to also consider the interests of non-shareholders, such as employees, consumers, the environment, and their community. Over half of the U.S. states authorize benefit corporations — or the similar, but not the same, public benefit corporation. For more information on benefit corporations, see Understanding benefit corporations.
Can I change my corporation status or convert a C corp to an LLC in the future?
Yes, you can convert a C corporation to an LLC should your business needs change. There are a number of ways this can be done. One way is the dissolve the corporation and then form the LLC. This is the most complex and expensive way and can have the most negative tax consequences.
Another way is to form the LLC and merge the corporation into it.
The third way, which is the most convenient, is through a statutory conversion. These are all statutory transactions and you will have to comply with what the corporation statute says.
The decision to convert must be approved by the shareholders. You should check the governing statute and the bylaws to see the percentage vote required. You will also have to file documents with the state of incorporation to make the conversion (or merger if that’s how you are doing it) effective. Conversion planning depends on your company’s specific circumstance, so be sure to discuss your plans with legal and tax professionals.
You can also change your tax status from C corporation to S corporation if you find that change beneficial and you meet all the qualifications of Subchapter S. This is done by completing IRS Form 2553 and filing it with the IRS.
What compliance rules must I follow as a C corporation owner?
C corporations need to have shareholders, directors, and officers. They must hold director and shareholder meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. A C corporation has to appoint and continually maintain a registered agent and registered office in the state of incorporation.
Your C corporation also needs to file annual reports (or biennial reports in some states), pay franchise taxes (which is a tax on the right to exist and do business in the corporate form), and maintain good standing in the state where you’re incorporated.
In addition, if your corporation wants to transact intrastate business in states outside of the state of incorporation, the corporation will have to qualify to do business in that “foreign state”, appoint and maintain a registered agent and office, and, in general, file an annual report and pay franchise taxes in the foreign state as well.
Do I need an attorney to form a corporation?
States may recommend that a lawyer guide the preparation of the Articles of Incorporation and other legal documents.
However, there is no requirement that a lawyer prepare the documents when forming a corporation.