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?
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.
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.
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:
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:
How to Set Up a C Corporation
Once you have an idea for a company, whether this means selling a product or a service, and you decide to set it up as a C corporation be prepared to devote time, use business methods, and get set up properly so you can make more money, minimize taxes, and generally avoid potential problems.
1. Choose a state in which to form your C corporation.
A C corporation is a creature of state law. It is formed under state law in accordance with the rules of each state. You can complete the set-up steps yourself or use an attorney for this purpose. Either way, there are state filing fees for incorporation that can range from $50 to $500 depending on state law.
Usually it is advisable to set up the corporation in the state in which you are based, rather than in another state that is considered to have laws more favorable to corporations, for example, Delaware or Nevada. For a small corporation, starting out and operating from a single state is less costly, avoiding the need to register to do business and, in some cases, pay additional taxes in multiple states. "If you form a corporation in Delaware or Nevada but are not actually doing business there, you will need to register your corporation as a 'foreign corporation' in the state where you are actually, physically, located, and pay taxes there" Ennico cautions, adding that "if you don't, you will be viewed as operating an illegal business in your state, and it will be only a matter of time before you receive a nasty letter from your state tax authority inviting you to come down for a chat."
2. Decide whether to incorporate on your own or get help.
There are many legal websites these days that enable you to incorporate a business on your own over the Internet. These services charge fees ranging from less than $100 to nearly $500 for do-it-yourself instructions, forms, and sometimes CD-Roms. These services include such sites as LegalZoom, The Company Corporation, and BizFilings.com, among other services. "Some of them are not bad. They tend to do a good job in completing the most important steps in incorporating a business such as filing the Certificate of Incorporation and getting your federal tax ID number (EIN) from the IRS," says Ennico. But Ennico cautions that "none of the do-it-yourself incorporation websites I'm familiar with complete all the steps, such as registering your corporation for state sales, payroll and other important taxes. The better websites will tell you where to go to complete these steps, but they leave it up to you to finish the job. If you're not disciplined enough to follow through, you may not have completed the incorporation process and that may cause problems for you down the road."
Ennico advises that businesses enlist an attorney or CPA to help them form a C corporation. The cost, he says, will usually range from $1,000 to $2,000 and is a good idea, because "that way, you know the job will be done 100% correctly, and if it isn't, you've got someone you can sue for any damages you may incur. The last time I looked, you cannot sue yourself for your own malpractice."
3. Write articles of incorporation.
Articles of incorporation act as a charter to create a corporation. "It's like the birth certificate of the corporation," Ennico says. "It's going to be a matter of public record." Each state dictates what must be included in order to form a corporation in that jurisdiction, Weltman says. Some states require several filings at different times so be sure to check your state's rules. Usually, Weltman says, the information must include the following
The articles of incorporation name the incorporator, who is the person or company responsible for filing required forms with the state, Weltman says. The articles of incorporation may also name the initial directors of the corporation -- the people taking control once the corporation comes into existence, she adds.
4. Write by-laws and a shareholder agreement.
To operate a corporation, there must be by-laws and other written guidance as dictated by the law in the state you incorporate in and dictated by good business practices.
By-laws are the governing rules for the corporation. "They stay in existence for as long as the corporation does, although they can and usually are amended from time to time," Weltman says. State law may outline many required rules; corporations can in some cases create their own rules. Weltman advises to include in the by-laws such information as:
"It is also advisable to create a shareholder agreement -- also referred to as buy-sell or buyout agreements -- to specify what happens to ownership interests in case of death, disability, retirement, bankruptcy or other contingency involving a shareholder," Weltman says. "For example, will a deceased-shareholder's shares be bought back ("redeemed") by the corporation or purchased by the remaining shareholders?"
5. Pay your taxes.
A C corporation is a separate taxpayer for federal income tax purposes. It files a return, IRS Form 1120, to report its income and expenses. There is a separate tax rate schedule for corporations, with rates ranging from 15 percent to 35 percent.
Shareholders of C corporations only pay tax when and to the extent they receive distributions from the corporation, Weltman says. These distributions can include:
There may also be state-level income taxes on C corporations in the states in which they do business. Usually there is a minimum payment required to do business in a state; this is sometimes called "a franchise tax" even though there is no franchise involved.
6. Attend to other details.
Make sure to deal with various other business matters before your begin operations: