Choosing the form of your business entity is one of the first and most important steps toward running a successful business. Three of the most common entity types are C-Corporations, S-Corporations and Limited Liability Companies (LLCs). Each entity type has its own advantages and disadvantages, including with respect to taxation, attractiveness to investors and simplicity. For most companies intending to raise money from venture capital funds, a C-Corporation is the most common choice. However, S-Corporations and LLCs provide tax advantages that may make them more suitable for certain businesses. This article addresses the pros and cons of C-Corporations, S-Corporations and LLCs, and how you can determine which one may be right for your business. Show
C-CorporationThe vast majority of our start-up clients elect to form their business as a C-Corporation due to its attractiveness to potential institutional investors, the well-established legal framework around corporate governance and the limited liability protection it provides to its owners. The largest drawback is potential double taxation. A C-Corporation is a separate taxpayer and pays its own taxes. As a result, any income earned by the C-Corporation is first taxed at the entity level and then again at the stockholder level when the net income is distributed to the stockholders. Who Should and Should Not Choose a C-Corporation?Any company planning to raise money from venture capital funds, tax-exempt investors or non-U.S. investors should strongly consider forming as a C-Corporation. However, if you do not anticipate raising funds from these types of investors and would prefer to avoid the double-taxation imposed on the C-Corporation, an S-Corporation or LLC may be better for you, as explained more fully below. Pros:
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S-CorporationPass-through taxation is the S-Corporation’s biggest appeal. In other words, the S-Corporation is taxed in a manner similar to a partnership where the income and losses pass through to the stockholders. The stockholders, not the S-Corporation, pay the tax on this income. The stockholders are not taxed again when this income is distributed to the stockholders. However, the S-Corporation is subject to strict requirements it must follow to qualify as and continue to be an S-Corporation. If any of these requirements are not met, the S-Corporation automatically reverts to a C-Corporation. One of these requirements is only U.S. individuals, certain trusts and certain tax-exempt organizations can own the stock, which substantially limits the company’s eligible investors. Another requirement is that the S-Corporation can only have one class of stock. Who Should and Should Not Choose an S-Corporation?If you plan to raise venture capital in the near-future, an S-Corporation is not a good choice because it cannot issue preferred stock and may not receive investments from entities. The S-Corporation may be a good choice for a family or closely-held business that relies solely on individual investors and does not expect to issue substantial equity incentives to its employees and consultants. Also, you can start as an S-Corporation and become a C-Corporation down the road if you decide to seek venture capital investors in the future. However, if pass-through taxation is the primary consideration, the LLC may be preferable to the S-Corporation, as further explained below. Pros:
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Limited Liability Company (LLC)A Limited Liability Company, commonly referred to as an “LLC,” enjoys pass-through taxation (similar to the S-Corporation) and provides more flexibility in the drafting of its governing documents. However, the LLC is also subject to several drawbacks, including unattractiveness to some institutional investors, difficulty issuing equity broadly, potential issues relating to convertible debt financings and the inability to conduct an initial public offering. Who Should and Should Not Choose an LLC?Similar to the S-Corporation, the LLC is not a good choice for companies intending to raise money from venture capital funds or other institutional investors, but may be a good choice for companies planning to raise funds through its founders, other individuals and corporate investors. In addition, if pass-through taxation is the primary consideration, the LLC may be a better choice than an S-Corporation because the LLC is not subject to the investor limitations applicable to an S-Corporation discussed above. Pros:
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So Which Entity Type Should You Choose?If your company anticipates seeking financing from venture capital funds or other institutional investors in the near future, we strongly recommend forming your company as a C-Corporation. Venture capital funds and other institutional investors generally expect to receive preferred stock in exchange for their investment in your company, which may only be issued by a C-Corporation. If you do not plan on seeking venture capital or other institutional financing, then an S-Corporation or an LLC may be a better choice as they each enjoy single-level taxation. In this case, we generally recommend forming an LLC because you will have access to a larger investor base and you are able to issue multiple share classes having different rights and preferences, similar to a C-Corporation. However, if you plan to run a family or closely-held business having only individual U.S. investors, and you don’t care about issuing different classes of equity, then an S-Corporation may be a better choice than an LLC because the governing documents are less complex than an LLC’s, equity awards are easier to grant and convertible note financings are less complicated. This article provides general guidelines and includes important factors for consideration in your entity selection. Because of the number of factors involved, there is not always one “right” answer, and these general guidelines may not apply to your situation. For example, initially forming your company as an LLC and later converting to a C-Corporation may make the most sense for you if you plan to initially self-fund your company and then seek venture financing several years after initial formation. This approach would allow the initial start-up losses to be allocated to your company’s founders and early-round investors, but would also allow you to seek venture financing when the time is right for you. Given all of the nuances involved with entity type selection, we recommend you seek the advice of legal counsel when deciding on the best entity type for your company. Subscribe To Viewpoints Which entity is subject to double taxation?Which Business Entities Experience Double Taxation? C-Corporations, or C-Corps (also known as just “corporations”), are the only business entity that experiences double taxation. Other business entities have different ways of paying taxes that don't involve a second form of payment.
What is an example of double taxation?Examples of Double Taxation
The United States' tax code places a double-tax on corporate income with one tax at the corporate level through the corporate income tax and a second tax at the individual level through the individual income tax on dividends and capital gains.
Which of the following types of business organizations subjects the owners to double taxation?A c-corporation is subject to corporate income tax on any corporate profits (entity pays taxes). Shareholders pay personal income tax on the corporate profits distributed by the corporation to the owners. As a result, C-corps are subject to “double taxation.”
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