Progress is driven by entrepreneurs like you. Every day, you take risks, moving quickly, adjusting to an ever-changing commercial environment. With one slip-up, legally, your progress can be halted. That is why it is important to start your business from a strong position.
As we discussed in the previous post, A Guide to Choose The Right Business Entity, the first step to setting up a business is deciding what entity type to set up. There are three major entity types that businesses can choose from: an LLC, a C-Corp, or an S-Corp. Each type has its own set of advantages and disadvantages. In this article, we will focus on C-Corps and their strengths and weaknesses to help you make an informed decision for your business. Seeking the guidance of an experienced business lawyer can help ensure that you select the corporate structure that best reflects the goals and needs of your business.
What Is the Purpose of a C-Corp?
The purpose of a C-Corp is to protect each individual owner’s assets from seizure if the corporation gets sued. C-Corps were created to replace traditional partnerships where each business partner was liable for the debt and mistakes of the business. This meant that if the business is sued, each individual partner’s personal assets, such as their home, could be seized to pay the debt. Instead, a C-Corp protects each individual partner’s personal assets allowing them to engage in business deals, they may not have otherwise if their personal assets were on the line.
What Are the Tax Options for C-Corps?
There is only one taxation option for the C-Corp, meaning that this entity is less flexible than an LLC in that regard.
What Are the Pros of a C-Corp?
Stock Types: C-Corps offer many different options when it comes to equity, particularly in stock. A C-Corp can have multiple different types of stock, such as common, preferred, voting or nonvoting stock. This also gives you options to allow your business to grow while giving various incentives for people to invest in your company.
Employee Stock Options: A C-Corp allows you to offer your employees stock options in the company as part of their compensation package. Another advantage to this is that giving an employee stock options makes them invest in the success of the business in a way that they may not otherwise have been.
Qualified Small Business Stock: Another benefit of forming a C-Corp is that its stock can qualify as Qualified Small Business Stock (or QSBS). If your business’s stock qualifies as QSBS, this potentially allows its owners to save up to $10 million in capital gains taxes or 10 times your adjusted base for the stock.
When examining the benefits of creating a C-Corp, it is important to consult with a qualified business attorney who can help you examine the goals and purpose of your business to give you advice and determine which entity type best fits your needs.
How Do You Qualify for Qualified Small Business Stock (QSBS)?
In order to qualify for QSBS, a business must meet the following general criteria:
The stock must be originally issued, meaning that it comes directly as an issuance from the company. It cannot come from a different partner or individual as a sale or transfer.
The stock must be held for a period of five years. This means that to qualify for the QSBS, the owner or investor in question must be willing to wait rather than get a quick return on their investment.
The stock in question must either be purchased for value or accepted as payment for services rendered.
Finally, 80% of the assets of the business must be used in a qualifying trade or business.
What Qualifies as a Qualifying Trade or Business?
Under 26 USCS § 1202, the IRS defines a qualifying trade or business as “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees” or is otherwise engaged in the business of finance, investment, banking or another similar business. An experienced business attorney will be able to help you determine if and how your business qualifies if you wish to take advantage of this option.
It is important to discuss both the goals and purpose of your business with your business attorney as well as your exit strategy to determine whether using the Qualified Small Business Stock option makes sense for you.
What Are the Downsides to Choosing a C-Corp.?
As with each of the three major types of corporate structures, C-Corps have their downsides that go along with the benefits.
Double taxation: One of the biggest downsides to a C-Corp is the double taxation that exists within it. This essentially means that both the corporation and the individual who receives dividends on the profits pay taxes on those profits to the IRS. For example, if a company makes $1 million in profit in a year, they pay 21% tax on the net profit. If they then pay out the rest of the profits to their owners and stockholders as dividends, those individuals pay taxes at whatever tax bracket they belong to on top of what the business has already paid. Therefore, if dividends on profits are going to be paid out every year, a C-Corp may not be the best option for your business. However, there may be a hidden benefit to selecting a C-Corp. even with the double taxation if you intend to keep profits within the business and your owners and shareholders are in higher tax brackets than the 21% paid by the corporation. Therefore, it is imperative to consider the tax implications of each type of entity when deciding which corporate structure to form for your business. Seeking the advice of a qualified business lawyer is critical to helping you successfully examine all of your options and make the best decisions for you and your business.
No Passthrough Losses: Another downside to forming a C-Corp is that there are no passthrough losses for the owners. For tax purposes, losses occur when a business spends more money than it earns. While the business itself can claim these losses on its taxes under a C-Corp, the owners cannot claim those losses on their personal tax returns.
Required Formalities: In order to form a C-Corp. and protect the individual owners’ personal assets, a C-Corp must have a Board of Directors with elections and meetings. The Board of Directors is responsible for making decisions for the business and must be consulted anytime the business wants to make a critical decision. The business must also have a yearly shareholder meeting in which shareholders who hold voting shares can vote on various aspects of business, including the election of members of the Board of Directors. If a C-Corp is sued and has failed to comply with these regulations it can mean that the C-Corp loses its protection and the individual owners can become liable for the liabilities of the business.
What Types of Businesses Are Best For C-Corps?
The businesses that tend to benefit most from using the C-Corp structure are those businesses seeking to eventually offer an Initial Public Offering (or IPO). In an IPO, a privately held company begins to sell stock to the public on public-traded stock exchanges. The benefit of an IPO is that a company begins to be publicly traded and they can use that as their main source of raising capital. Given the flexibility with the different types of stock a C-Corp can offer, this makes it an ideal corporate structure for those businesses seeking to be publicly traded.
Another ideal candidate for the C-Corp structure is a high-growth startup looking to obtain backing from investment firms or venture capitalists. Investment firms tend to look favorably on businesses formed as C-Corps because the investment packages tend to be simpler and the growth and equity for investors are also easier to understand. It also has tax benefits for charitable or foreign investors. For many investors, the Qualified Small Business is also an attractive option because it allows the investor to save on capital gains taxes provided that they are willing to hold onto the stock for five years.
The Bottom Line
In the end, it is very important for you to choose the business entity that is right for you. Keep in mind how it will affect your business, finances, and legal exposure. And while you choose your business entity, whether a C-Corp or another type, make sure that your CPA and your business lawyer agree with your choice.
As entrepreneur lawyers, we appreciate your path as a business owner. We love working with bold visionaries like you that navigate your industry with purpose. That is why we are here, to help you navigate hidden legal risks so that you can focus on your business.
For any queries and doubts that you have, talk to your business lawyer and tax attorney. In fact, we offer these services and can help you. So, if you need help with choosing your business’s type and starting your business, Freeman Lovell can help you. Feel free to reach out to me at email@example.com or click on the button at the upper right corner of the website to contact us to learn more!