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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.
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.