First, the common wisdom of why not to do C-corporations: Many practitioners argue that there is no such thing as the emerging growth C-Corporation. Their argument falls along the lines that very few start-ups need to immediately consider the pros of unlimited shareholders and large growth. Unless you’ve made a better mousetrap and can virtually guarantee investors pounding down your door for a share of the action, your company’s growth is will not require C-Corporation status.
Additionally, it is easy to argue that while it is relatively easy to transition from an LLC to a C-Corporation, it is much more difficult to switch from a C-Corporation to an LLC. The former being a tax-free event, the latter being a taxable event. Thus, the common rationale is that it is better to begin as an LLC or S-Corporation and then move to a C-corporation.1
Why then would you ever purposefully disadvantage yourself from a tax benefit standpoint?
First, venture capitalists often have a preference for working with C-Corporations rather than LLCs or S-Corporations. Both LLCs and S-Corporations are taxed at the shareholder level. Thus, they produce each year a K-1 with the business’ tax loss or gain. The shareholder is then required to pay taxes.
For this reason, some (but not all) disfavor LLCs and some will not invest in LLCs, period. Additionally, S-Corporations can only have individuals as shareholders; thus, all corporations/ LLCs/ institutional investors cannot invest in S-Corporations without running afoul of the IRS requirements for S-Corporations (aka “blowing the S”).
It is a correct statement that you limit the universe of investors with an LLC or S-Corporation. C-corporations have no restrictions on shareholders, so technically you have not limited yourself. But this, in and of itself, is not reason enough to choose C-Corporation status. Indeed, unless you (a) have experience and (b) live in Silicon Valley, if you do it for this reason alone, I think you look pretty foolish. (And by looking foolish, you drive off more investors than you could ever attract.) While healthy optimism is always appreciated, irrational exuberance is usually frowned upon. And the bottom line, in all of this, is that the money (i.e. the v.c or p.e. or w.e.w.m.2) gets to make the choice of entity call 95% of the time.
That said, there are legitimate reasons to choose C-Corporation status. First, the conversion is difficult. So if the funding is close, a C-Corporation is potentially right. While it is tax free, the state law mechanism is relatively new. Additionally, there may be basis issues, and if you have issued profit interest, you may have to work through some issues. These are not fatal to the plan, but I do think the thought that a conversion is automatic is an oversimplification.
However, the better logic for a C-Corporation lies in the presumption that a C-Corporation is terrible from a tax perspective. This presumption is correct, but I believe overstated. First, you have to have income to have income tax. It seems simple, but it is often overlooked. A lot of time and energy is put into tax planning based on false expectations of profit (more delusions of grandeur). If you never have income, you have no problem. Additionally, if you take salary, you can lower any taxable income.3
Also, if you sell the stock, you do not have to pay two levels of income tax, thus a company can reinvest in non-capital projects4, make no income, sell the stock and be at exactly the same place tax-wise as an S-Corporation or LLC.
There is some simple elegance to the C-Corporation as well. When you have a flow through, you have to provide5 the cash for such taxes. When you start providing cash (for whatever reason), it is sometimes hard (for whatever reason) to stop. Once the levee is breached, the expectations for money are always there. C-Corporations do not have this issue.
There are some other benefits to C-Corporation status:
- Lower risk of audit.
- Possible qualified small business stock (see next week).
- Easier documentation of preferred shares (complicated in an LLC, not possible in an S-Corporation).
- Cost of business is a business expense. Health plans and other benefits are tax-free.
- Because C-Corporations allow for an unlimited amount of shareholders, company founders can seek funding from an unlimited number of sources.
- C-Corporations can sell stock when it’s time for expansion or additional funds are required.
- Because C-Corporations can have both domestic and foreign investors, the opportunity to raise more money is again improved.
- C-Corporations offer different groups of stock. Preferred, “A” class stock, “B” class stock, etc. allow for investors to come into the corporation at different levels, depending on their level of comfort and amount of desired investment.
C-Corporations also go on whether or not shareholders leave the company or pass away. Changes in shareholder status do no affect the structure or existence of the company.
However, C-Corporations have two major drawbacks:
- Double taxation: C-Corporations are taxed on company profits and taxed again when those profits are distributed to individual shareholders.
- Corporate losses are not tax deductible.
While it might be a risky move, the unlimited domestic and foreign shareholders, preferred classes of stock and appeal to venture capitalists offer some compelling arguments for C-Corporation status.
Goodrich Law Firm, LLC
1 For the record, I still subscribe to this rationale in most situations and present the counter pro C-Corp argument for the sake of discussion.
2 Whoever has the money.
3 This creates a “reasonable compensation” issue. Owners will inflate their salary and zero out net income. The IRS frowns upon this. Note that this is the exact opposite of the FICA/S-Corporation issue where owners deflate their salary.
4 Which is common in technology and other organizations that invest in people, not facilities.
5 By “have to” I mean, you either should or your shareholders get mad, or you should because you have an operating agreement or shareholder agreement that requires you to make such distributions.