Many entrepreneurs (and some of their non-lawyer advisors) confuse the concepts of C-Corp and corporation, or S-Corp and LLC. In this post I will give you the straight skinny. There are two concepts your lawyer must consider when forming your company: governance and tax filing status. (Your CPA almost exclusively thinks about taxes.)
For governance your company can be an LLC or a corporation—you cannot “create a C-Corp,” and you cannot “create an S-Corp,” because those designations are not recognized in any state—C-Corp and S-Corp are IRS tax filing statuses that not limited to corporations. We HIGHLY recommend being an LLC. It is WAY more flexible in how you can govern your company than the corporate form.
Lots of people ask, “If an LLC is better, then why do so many investors require having a corporation?” The short answer is that it is a dwindling number of investors who still stick to that requirement. Last time I heard any knowledgeable claim about the percentage was almost two years ago, and even then it was only 25% who want to see only a corporate structure. That number is probably even lower now. The argument sometimes given is that investors don’t want to devote lawyer time to studying the governance documents of an LLC. This is a bogus argument, because no investor would enter any deal without a detailed analysis of the target company’s corporate documents, LLC or corporation.
By the way, no matter which governance type you choose, LLC or corporation, you should have a negotiated agreement among the owners of your closely held company—it’s typically called an “operating agreement” for an LLC and a “shareholder agreement” for a corporation. This agreement would stipulate things like share transfer restrictions, who has responsibility for managing the company, what happens if an owner dies or becomes incapacitated, expectations about owner participation in the company’s operations, and a whole lot more.
Tax Filing Status
Once you select the type of governance, either LLC or corporation, you can elect which way to file your taxes with the IRS. LLC’s have 3 ways to choose from: Partnership (default), S-Corp, and C-Corp. Corporations have only 2 ways: S-Corp or C-Corp (default). But in no way does your LLC convert to a corporation for governance purposes merely because you elect to have the company file tax returns as an S-Corp or S-Corp.
The most cost-effective tax filing status for most small businesses is generally the S-Corp filing status (and that is what we almost always recommend). Company’s that file the S-Corp tax return (1120-S) do not pay taxes at the company level, and all of the company’s profits flow to its owners tax returns.
If there is a compelling reason, you can elect C-Corp tax status, or even just leave the company to be taxed as a partnership, which it will be if you don’t file an election for one of the other options. Partnership also don’t pay taxes at the company level, as they are also “flow through” entities wherein the owners pay all the taxes. But companies that file as C-Corporations do pay income tax, and then if the company pays distributions from it profits (called dividends), the owners pay tax again on those distributions. That double taxation of dividends is why few closely held businesses want to be taxed as a C-Corp.
One of those compelling reasons for being taxed as a C-Corp is that you might have a non-US person as one of your investors. That is not permitted for S-Corp tax status. So as an LLC you’d have to elect to be taxed as a partnership or C-Corp. Either way, there will be additional reporting requirements, so check with your tax professional in this situation.
Hopefully you now understand the difference between being a corporation and an LLC, vs being taxed as an S-Corp or C-Corp.
Entrepreneurs are going to save the world, and Argent Place Law wants to help. That’s why we are a team of entrepreneur-lawyers serving Entrepreneurs just like you. Think how great it will be to have a legal team with entrepreneurial experience on your speed dial so you can call us up and say, “I’m bringing on a silent partner as part owner in my company. What do I do?” Contact Argent Place Law to find out: 703-539-2518.