Appendix B: C Corps, LLCs, and S Corps

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Appendix B: C Corps, LLCs, and S Corps

Choice of Entity

founder If you are going to start a company, one of the first legal decisions you will have to make is what type of entity to form. This can be a more complex question than you might think.

In general, for federal income tax purposes, there are three types of entities to choose from:

  • C Corporations,

  • S Corporations, or

  • LLCs taxed as partnerships.

(This outline doesn’t consider other potential entity choices, like public benefit corporations, social purpose corporations, cooperatives, et cetera.)

What primarily differentiates these business entities from one another is their federal income tax characteristics:

  • C Corporation. A C Corporation is an entity that, in contrast to an S Corporation or an LLC taxed as a partnership, is subject to federal income tax and pays federal income taxes on its income. Its shareholders are not subject to tax unless the corporation pays amounts to them in the form of dividends, distributions, or salary.

  • S Corporation. An S Corporation is not subject to federal income tax. Instead the company’s shareholders pay federal income tax on the taxable income of the S Corporation’s business based on their pro rata stock ownership.

  • LLC. LLCs, like S Corporations, are “pass-through” entities, which means that their owners (referred to as members) pay the tax on the income of the LLC that is allocated to them based on the LLC agreement. For a sole member, unless an election is made to be taxed as a corporation, the LLC is treated as a “disregarded entity,” meaning that the sole member reports the LLC’s income or loss on his or her tax return just like a sole proprietorship, or division in the case of a corporate owner. For purposes of this discussion, when we talk about LLCs we are talking about LLCs that have more than one member and haven’t made any elections to be taxed as C corporations or S corporations, but instead are taxed as partnerships for federal income tax purposes. For LLCs with multiple members, the LLC is treated as a partnership and must file the IRS Form 1065 (unless the entity elects to be taxed as a corporation). The members of the LLC are treated as partners for federal income tax purposes and each receives a Form K-1 reporting their share of the LLC’s income or loss for the members to report on their federal income tax return.

C Corps vs. S Corps

C Corporation Advantages/S Corporation Disadvantages

  • Investors generally prefer C corporations. If you plan to raise money from investors, then a C corporation is probably a better choice than an S corporation. Your investors may not want to invest in an S corporation because they may not want to receive a Form K-1 and be taxed on their share of the company’s income. They may not be eligible to invest in an S corporation. Thus, if you set yourself up as a C corporation, you will be in the form most investors expect and desire, and you will avoid having to convert from an S corporation or an LLC to a C corporation prior to a fund raise.

  • Only C corporations can issue qualified small business stock. C corporations can issue qualified small business stock. S corporations cannot issue qualified small business stock. Thus S corporation owners are ineligible for qualified small business stock benefits. Currently, the QSBS benefit is a 100% exclusion from tax up to $10M, for gain on the sale of qualified stock held for more than five years, and the ability to roll over gain on the sale of qualified stock into other qualified stock. This is a significant potential benefit to founders and one reason to not choose to form as an S corp.

  • Traditional venture capital investments can be made. C corporations can issue convertible preferred stock, the typical vehicle for a venture capital investment. S corporations cannot issue preferred stock. An S corporation can only have one class of economic stock; it can have voting and non-voting common stock, but the economic rights of the shares (as opposed to the voting characteristics), have to be the same for all shares in an S corporation.

  • Retention of earnings/reinvestment of capital. Because a C corporation’s income does not flow or pass through to its shareholders, C corporations are not subject to pressure from their shareholders to distribute cash to cover their shareholders’ share of the taxable income that passes through to them. An S corporation’s pass-through taxation may make conservation of operating capital difficult because S corporations typically must distribute cash to enable shareholders to pay the taxes on their pro rata portion of the S corporation’s income (S corporation shareholders are taxed on the income of the corporation regardless of whether any cash is distributed to them).

  • No one class of stock restriction. S corporations can only have one class of stock; S corporations cannot issue preferred stock, for example. But this restriction can arise in other situations unexpectedly, and must be considered whenever issuing equity, including stock options or warrants.

  • Flexibility of ownership. C corporations are not limited with respect to ownership participation. There is no limit on the type or number of shareholders a C corporation may have. S corporations, in contrast, can only have a limited number of shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders (all shareholders must be U.S. residents or citizens).

  • More certainty in tax status. A C corporation’s tax status is more certain than an S corporation’s tax status. For example, a C corporation does not have to file an election to obtain its tax status. S corporations must meet certain criteria to elect S corporation status, must then elect S corporation status, and then not “bust” that status by violating one of the eligibility criteria.

S Corporation Advantages/C Corporation Disadvantages

  • Single level of tax. S corporations are pass-through entities: their income is subject to only one level of tax, at the shareholder level. A C corporation’s income is subject to tax, and any “dividend” distributions of earnings and profits to shareholders that have already been taxed at the C corporation level are also taxable to the shareholders (i.e. income is effectively taxed twice). This rule is also generally applicable on liquidation of the entity.

  • Pass-through of losses. Generally, losses, deductions, credits, and other tax benefit items pass through to a S corporation’s shareholders and may offset other income on their individual tax returns (subject to passive activity loss limitation rules, at-risk limitation rules, basis limitation rules, and other applicable limitations). A C corporation’s losses do not pass through to its shareholders.

  • Simplicity of structure. S corporations have a more easily understandable and simpler corporate structure than LLCs. S corporations can only have one class of stock—common stock—and their governing documents, articles, and bylaws are more familiar to most people in the business community than LLC operating agreements (which are complex and cumbersome and rarely completely understood).

C Corps vs. LLCs Taxed as Partnerships

C Corporation Advantages/LLC Disadvantages

  • Traditional venture capital investments can be accepted. The issuance of convertible preferred stock by C corporations is the typical vehicle for venture capital investments. Venture capitalists typically will not invest in LLCs and may be precluded from doing so under their fund documents.

  • Traditional equity compensation is available. C corporations can issue traditional stock options and incentive stock options. It is more complex for LLCs to issue the equivalent of stock options to their employees. Incentive stock options also are not available to LLCs.

  • Ability to participate in tax-free reorganizations. C corporations can participate in tax-free reorganizations under IRC Section 368. LLCs cannot participate in tax-free reorganizations under IRC Section 368. This means that if you think your business may get acquired by a company in exchange for the acquiror’s stock, a C corporation would be a good choice of entity.

  • Qualified small business stock benefits. C corporations can issue qualified small business stock. LLCs cannot issue qualified small business stock. Thus, LLC owners are ineligible for qualified small business stock benefits, which is the 100% gain exclusion of up to $10 million on the sale of qualified stock held for more than five years, and the ability to roll over gain on the sale of qualified stock into other qualified stock.

  • Self-employment taxes. C corporation shareholders are not subject to self-employment taxes on the corporation’s income. An LLC’s members are generally subject to self-employment tax on their distributive share of the LLC’s ordinary trade and business income.

  • Retention of earnings/reinvestment of capital. A C corporation’s income does not flow or pass through to its shareholders; this makes it easier to retain and accumulate capital because a C corporation will never have to distribute cash to its stockholders so that they can pay the tax on the entity’s income. LLC’s pass-through taxation can make conservation of operating capital difficult. LLCs typically distribute cash to enable members to pay the taxes on their share of the LLC’s income (LLC members are taxed on the income of the LLC allocated to them regardless of whether any cash is distributed to them).

  • Fringe benefits. C corporations have more favorable treatment of fringe benefits. LLC members cannot be considered “employees” for federal income tax purposes and therefore must pay self-employment taxes; fringe benefits of LLC members are generally included in income.

  • State income tax return filing requirements. Each member of the LLC may be required to file a tax return in multiple states. This is not the case with C corporations.

  • Complexity/uncertainty. The flexible nature of LLCs makes them more complex. Partnership tax is also substantially more complex than C corporation tax. The relatively new nature of the LLC form and limited amount of case law make LLC transactions more complex and uncertain than their corporate counterparts.

  • Tax rates. Individual income tax rates can be higher than the highest stated corporate tax rates. At the time of this writing, the top C corp tax rate was 21%, and the top individual income tax rate was 37%.

  • Administrative burdens. Partnership tax accounting is more complex than C corporation accounting.

  • Withholding on foreign members’ distributive shares. An LLC has to withhold taxes on certain types of income allocated to foreign persons, regardless of whether distributions are made. C corporations are not subject to this requirement.

LLC Advantages/C Corporation Disadvantages

  • Single level of tax. LLCs are pass-through entities: their income is subject to only one level of tax, at the member level. A C corporation’s income is subject to tax, and any “dividend” distributions of earnings and profits to shareholders that have already been taxed at the C corporation level are also taxable to the shareholders (i.e. income is effectively taxed twice).

  • Pass-through of losses. Generally, losses, deductions, credits, and other tax benefit items pass-through to an LLC’s members and may offset other income on their individual tax returns (subject to passive activity loss limitation rules, at-risk limitation rules, basis limitation rules, and other potential limitations). A C corporation’s losses do not pass-through to its shareholders.

  • Tax-free distributions of appreciated property. An LLC can distribute appreciated property (e.g. real estate or stock) to its members without gain recognition to the LLC or its members, facilitating spin-off transactions. A C corporation’s distribution of appreciated property to its shareholders is subject to tax at the corporate level and possibly tax at the shareholder level as well. (It is for this reason that entities formed to invest in real estate or the stock of other companies should not be C corporations).

  • Tax-free formation. Appreciated property can generally be contributed to LLCs tax-free under one of the broadest nonrecognition provisions in the IRC (IRC Section 721). Tax-free capitalizations for C corporations must comply with the more restrictive provisions of the IRS to be tax free (i.e. IRC Section 351) (although this is not usually a problem).

S Corps vs. LLCs Taxed as Partnerships

S Corporation Advantages/LLC Disadvantages

  • Sales of equity. S corporations can more easily engage in equity sales (subject to the one class of stock and no entity shareholder restrictions, generally) than LLCs. For example, because an S corporation can only have one class of stock, it must sell common stock in any financing (and this makes any offering simpler). An LLC will have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity (although its S corporation status will have to be terminated prior to such an event). As a practical matter, an LLC will likely need to convert to a corporation before entering the public equity markets, because investors are more comfortable with a “typical” corporate structure.

  • Traditional equity compensation available. S corporations can adopt traditional stock option plans; in addition, they can grant incentive stock options. It is very complex for LLCs to issue the equivalent of stock options to their employees (although they can more easily issue the equivalent of cheap stock through the issuance of profits interests—see below). Incentive stock options also are not available for LLCs.

  • Ability to participate in tax-free reorganizations. S corporations, just like C corporations, can participate in tax-free reorganizations under IRC Section 368. LLCs cannot participate in a tax-free reorganization under IRC Section 368.

  • Ease of conversion to C Corporation status. It is typically easier for an S corporation to convert to a C corporation than it is for an LLC to convert to a C corporation. For example, upon accepting venture capital funding, an S corporation will automatically convert to a C corporation. For an LLC to convert to a state law corporation taxed as a C corporation, it is necessary to either convert the LLC to a corporation pursuant to a state law conversion statute, or form a new corporate entity to either accept the assets of the LLC in an asset assignment or into which to merge the LLC. Also, converting an LLC to a C corporation may raise issues relating to conversions of capital accounts into proportionate stockholdings in the new corporation that are not easily answerable under the LLC’s governing documents.

  • Simplicity of structure. S corporations have a more easily understandable and simpler corporate structure than LLCs. S corporations can only have one class of stock—common stock—and their governing documents, articles and bylaws, are more familiar to most people in the business community than LLC operating agreements (which are complex and cumbersome and rarely completely understood).

  • Self-employment taxes. S corporation shareholders are not subject to self-employment taxes. S corporation shareholders who are employees are taxed as employees and receive a Form W-2, not a Form K-1. An S corporation structure may result in the reduction in the overall employment tax burden. LLC members are generally subject to self-employment tax on their distributive share of the LLC’s ordinary trade or business income. LLC members cannot be employees for federal income tax purposes and thus cannot receive Forms W-2.

  • Fringe benefits. Only 2% or greater shareholders of S corporations have to include certain fringe benefits in income; generally all fringe benefits of LLCs are included in the income of the members, regardless of their percentage of ownership.

Advantages of LLCs Taxed as Partnerships/S Corporation Disadvantages

  • Flexibility of ownership. LLCs are not limited with respect to ownership participation. There is no limit on the number of members an LLC may have. S corporations, in contrast, can only have a limited number of shareholders. Similarly, LLCs may have foreign members (although upon becoming a member of an LLC, a foreign member may suddenly become subject to the U.S. tax laws and have to file a U.S. tax return filing; additionally, an LLC will have to withhold on any income allocated to a foreign member; S corporations cannot have foreign shareholders (all shareholders must be U.S residents or citizens). As a practical matter, however, an LLC is not a viable choice of entity for a company that will have foreign investors or investors that are themselves pass-through entities with tax-exempt partners, because such investors may refuse or not be able to be members of an LLC.

  • Special allocations of tax attributes. An LLC has flexibility to allocate tax attributes in ways other than pro rata based on stock ownership. An S corporation’s tax attributes must be allocated to shareholders based on the number of shares they own.

  • Debt in basis. An LLC member’s basis for purposes of deducting pass-through losses includes the member’s share of the entity’s indebtedness. This is not the case with S corporations.

  • More certainty in tax status. S corporations must meet certain criteria to elect S corporation status; they must then make an election; they must then not “bust” that status by violating one of the eligibility criteria. LLCs generally do not have to worry about qualifying or continuing to qualify for pass-through treatment.

  • Tax-free distributions of appreciated property. An LLC can distribute appreciated property (e.g. real estate or stock) to its members without gain recognition to the LLC or its members, facilitating spin-off transactions. An S corporation’s distribution of appreciated property to its shareholders results in the recognition of gain by the S corporation on the appreciation, which gain then flows or passes through to the S corporation’s shareholders.

  • Profits interests. It is possible to grant “cheap” equity to service providers through the use of “profits interests” under Rev. Proc. 93-27. See also Rev. Proc. 2001-43. It is more difficult for S corporations to issue cheap equity without adverse tax consequences to the recipients.

  • Payments to retiring partners. Payments to retiring partners may be deductible by the partnership; payments in redemption of S corporation stock are not deductible.

  • Ease of tax-free formation. Appreciated property can be contributed tax-free to LLCs under one of the most liberal nonrecognition provisions in the IRC. Contributions of appreciated property to S corporations in exchange for stock must comply with more restrictive provisions of the IRC to be tax-free (i.e. IRC Section 351) (although this is not usually a problem).

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