The Pros and Cons of Setting Up a C Corp
Converting a company to a C Corp can help you establish some legal and financial separation between you and your business. But the switch involves more paperwork and red tape, and you could face double taxation. Do the benefits of being a C Corp outweigh the risks?
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A great way to build some legal protection into your business is to incorporate. Many people incorporate to gain limited liability to protect personal assets from company liabilities such as lawsuits or creditors. Incorporating also can reduce a business' taxes if it earns a lot of revenue, make it easier to seek venture capital or other outside investment, and in some cases provides more flexibility for your business.
For federal income tax purposes, corporations are governed by the Internal Revenue Code and there are different types of corporate structures to consider. The basic type of American corporation is governed under Subchapter C of the Internal Revenue Code, so they are called C corporations. S corporations start out as C corporations but make a special tax election to have income, deductions, etc. taxed directly to shareholders (S corporations are governed by Subchapter S).
From a legal standpoint, C corporations are separate entities that can sue and be sued. From a tax standpoint, they are separate taxpayers, paying tax at special corporate tax rates that differ from those applicable to individuals. Whether you are in business by yourself or with one or many other co-owner and want to set up a C corporation, be sure to follow certain legal and practical steps to help ensure success.
The following sections will review what a C corporation is, the pros and cons of structuring your business as a C corporation, and how to go about setting up a C corporation.
Dig Deeper: How to Choose the Right Legal Structure
Forming a C Corporation
Among the different types of business structures available in the U.S., almost all larger corporations with more than 100 shareholders and virtually all publicly traded companies are C corporations. All companies that are considering going public, seeking venture capital, or taking on equity investors are also usually C corporations. That doesn't mean, however, that a small business or a sole proprietor is barred from becoming a C corporation.
"A C corporation can consist of one person, anybody over the age of majority. There is no restriction," says Cliff Ennico, an attorney and nationally syndicated small business columnist and author of Small Business Survival Guide (Adams Media 2005). "The law recognizes that you can form a corporation for the sole purpose of limiting your personal liability for business debts, agreements and lawsuits, and, as long as you follow the rules regarding corporations, it should be there to protect you."
Many smaller businesses, however, choose to start off as a limited liability company (LLC) or an S corporation. There are several reasons. LLCs don't require formal meetings and generally have less paperwork involved. Both LLCs and S corporations are "pass-through" entities for the purpose of taxation, meaning that the business isn't taxed but profits or losses pass through to the shareholders to include on individual tax returns. That is significant if the business isn't making a lot of money or incurs a loss because individuals may take that loss against other income on their tax returns. S corporations are limited to 100 or fewer shareholders, but about 97 percent of S corporations have three or fewer shareholders, according to Barbara Weltman, a tax and business attorney and author of such books as J.K. Lasser's Small Business Taxes (Wiley 2009).
Most start-ups register first as an LLC or S corporation because they can always file to become a C corporation at a later date. "Very commonly what people do is form an S corporation during the early years of their business, when they are losing money, so that the losses flow through to owners. Then, as soon as the business becomes profitable, they switch it to a C corporation to shelter some of the profits from taxes," Ennico says. Once an S corporation becomes a C corporation, however, it may have to wait a few years before it can elect to be taxed as an S corporation again. Also, Ennico points out that it may be extremely difficult to convert a C corporation into an LLC without adverse tax consequences.
Dig Deeper: Searching for the Perfect Form
Benefits of using C corporation format
There are a few key reasons for opting to create a C corporation, as opposed to the other business structures, according to Weltman. These include the following:
- The opportunity to use a medical reimbursement plan. "This enables the corporation to deduct all medical payments up to a fixed dollar amount (set by the corporation, not tax law) while shareholders-employees enjoy this benefit on a tax-free basis," Weltman says.
- The need for venture capital. A business that needs substantial start-up and/or expansion capital (more than $5 million) may turn to venture capitalists for help. "Usually, such financiers are interested providing money for businesses organized as C corporations because there is more flexibility in making ownership arrangements," Weltman adds.
- The intention to take the company public. If there is the potential for growing the business to such a level that it can attract financing by becoming a public company traded on a national exchange (such as the New York Stock Exchange), the business must be a C corporation, Weltman says.
- Tax considerations: Besides the opportunity for shareholder-employees to obtain tax-free fringe benefits, there is another key tax edge for C corporations: The ability to accumulate earnings for future expansion at a lower tax cost than other types of entities.
Dig Deeper: The Fringe Benefits of Forming a C Corp
Drawbacks of Using C Corporation Format
There are also several reasons that argue against forming a C corporation if your business has the option to form under a different legal structure. These include the following:
- The potential for "double taxation." The chief drawback of a C corporation is the so-called "double taxation" potential. "Profits are first taxed to the corporation," Weltman says. "Then, when they are distributed to shareholders in the form of dividends, they are taxed again; the corporation cannot deduct dividend distributions." However, the threat of a double tax can sometimes be mitigated for following certain strategies.
- The requirement to file more paperwork. Corporations are required to hold formal board and shareholder meetings and keep accurate minutes of these meetings. In addition, there are a series of tax forms that may need to be filed with federal, state, and even local officials, including corporate taxes (IRS Form 1120), taxes on salaries and other employee compensation (W-2s), and profit distribution to shareholders (Form 1099-DIV). "A C corporation complicates your life," Ennico says. "Most entrepreneurs I work with want to spend their time making or selling their products. They don't want to stay up until 3 a.m. doing paperwork."
- Filing corporate tax forms may require an accountant. The tax forms for corporations can be complicated and may require you to get some help from an accountant. In addition, corporations have to pay federal taxes by March 15 -- a full month before the individual federal tax filing deadline.
Dig Deeper: The Problem of Double Taxation
