C Corps vs. S Corps

You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.

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 from tax on up to the greater of either $10M of gain or 10X the adjusted basis of qualified small business stock issued by the corporation and sold during the year, QSBS 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).