Choosing the right structure for your business is one of the most important steps you will take in your company’s journey. The right structure will protect you from liability, ensure maximum tax advantages, and position you for success. The first question is whether to incorporate your business at all.  This decision requires, at a minimum, a basic understanding of the advantages and disadvantages of corporations.

What are the Different Types of Corporations?

There are two primary types of corporations:

  • General Corporations, or “C” Corporations, is the most common business structure in the United States.  C Corporations are able to issue shares to raise funds from investors.  C Corporations have an unlimited number of shareholders. These shareholders are protected from business liabilities.  However, C Corporations are usually subject to double taxation, meaning that they are taxed twice. The corporation’s income is taxed at the company level, and then again at the shareholder level since shareholders are taxed when they receive profits or dividends from the company.  ​
  • S Corporation is an IRS designation that allows the profits and losses to be passed through to the owners’ personal tax returns. This structure also limits personal liability, but an S corporation is limited to 100 U.S. resident shareholders.

In addition, while not available in all states, an entrepreneur may be able to form a close corporation – generally with a limit of 30 to 50 stockholders.  This structure is less common and used when there are only a few individuals who are closely associated with the business.  Usually, a close corporation may not be publicly traded, and can be run directly by the shareholders (without a formal board of directors and without a formal annual meeting).  Close corporations shares have limited resale value.

What are the Advantages and Disadvantages of a C Corporation?

Advantages

  • Limits on Liability. Corporations are entities of their own. This means the owners of the company are not personally liable for the debts or other liabilities of the business.  However, in some limited situations, it may be possible for an outside party to “pierce the corporate veil” and hold the owners personally liable (e.g., the person fails to treat the company as a separate entity instead of an extension of her personal property).

  • Risk to Shareholders.  Each shareholder is risking only the amount of her investment in the company.

  • Raising Money.  Additional funds may be raised at any time by selling shares in the company to other investors.  A corporation also may be considered more credible by lenders, customers and suppliers.  Foreign nationals can own stock in a C Corporation (unlike an S Corporation).

  • Tax Liability of the Corporation.  Shareholders and company founders cannot be held personally liable for tax liabilities in a C Corporation.

  • Benefits to Employees.  Corporations may deduct the cost of benefits to employees and officers of the corporation on their taxes.

  • Longevity.  Unlike a sole proprietorship, a company can survive its founder. In the event of death or disability of a company founder, the corporation lives on.

  • Transfer of Ownership.  A C corporation can be easily transferred to another person or company.  A change in ownership does not impact the business structure.

  • Income Splitting to Reduce Taxes.  The company can reduce taxes by using income splitting to leave money in the company without paying taxes on it or shifting profit around and using lower corporate income tax rates.

  • Few Legal Surprises. Corporations have been around for centuries so there are a lot of case law examples and few, if any, legal surprises.  In addition, corporation rules are fairly uniform across the country.

  • Other Tax Advantages.  While C corporations are subject to double taxation, there are also some valuable tax deductions that can reduce the overall taxable income including:

    • Medical Insurance.  Most corporations can deduct the full cost of medical insurance for families of the owner(s).

    • Retirement Plans.   If setup properly, a retirement plan can be set up as a benefit to the company owners and may be deductible.

    • Profits and Losses.  While C corporations are taxed on their profits, they are also able to fully deduct any losses on operations from their corporate tax returns.

    • Carried Profits.  A corporation may carry their profits forward for future expansion; no distribution of profits is required which may have tax benefits.

    • Salaries and Profits. Only salaries drawn by the founders are subject to self-employment taxes. Profits and salaries must be properly structured to gain this benefit.

    • Leasing Assets.  If done properly, you can lease certain personal property such as your vehicle to the business which allows you to deduct the cost of repairs and maintenance as well as the rental of the vehicle.

Disadvantages

  • Expenses Involved.  When forming a corporation, it is typically more expensive and takes more time than other business structures. In addition to start-up fees, most corporations are subjected to annual fees as well on a state level.

  • Double Taxation.  Profits of a corporation are taxed at the corporate level and when distributed to shareholders are also taxed at the personal level. Dividends are not deductible from business income.

  • Annual Reporting.   Annual reports, corporate income taxes are required for corporations. In addition, accounting records must be maintained; other reports including minutes of meetings of both board members and shareholder meetings. There are licenses that must be renewed annually in many cases.  Along the same line, C corporations generally tend to experience more government oversight.

  • Excessive Tax Filings. A C corporation is required to file state and local income taxes. In addition, depending on the type of business, the business also may be required to pay local taxes, sales taxes and excise taxes. Corporations with employees must make regular payroll tax filings.

  • Board of Directors Restrictions.  Federal and state laws apply to all corporations. In many cases, there can be restrictions on the number of family members who may be on the board of directors.

  • Potential Agency Problems.  In some cases, boards may hire an outside management agency. The potential exists that the management agency could act in their interest versus the interests of the corporation.

  • Shareholders are separated from the business operations.  Shareholders are considered the owners of the corporations, but only have the power to elect directors unless they are voting for approval of major corporate decisions. Shareholders can be elected as a director or appointed as an officer.

  • Strict Management Structure. Corporations must have a corporate structure with a Board of Directors who handle the management responsibilities of increasing shareholder profits and allocating company resources and corporate officers who handle the day-to-day operations.

  • Increased Taxation on Salaries. Salaries face Medicare and Social Security taxation.

  • No Tax Savings on Operating Losses. C corporation shareholders can't deduct operating losses.

Additional Advantages and Disadvantages of an S Corporation

Advantages

  • Advantage for Business Losses. This allows business losses to be passed through to individuals to be used as deductions on their personal income taxes.

  • Self-Employment Taxes.  S Corporations allow individuals to save on self-employment or Social Security/Medicare taxes in addition to reducing non-business income using losses from the business. However, C corporations cannot do this since they are a completely separate tax entity.

  • Business Expense Tax Credits. The shareholder/employees can write off certain business expenses.

Disadvantages

  • Less Flexible Stock Classes. S corporations can have only one class of ownership.

  • Profits and Losses Allocated on Percentage Ownership. Since S corporations must have only one class of ownership, profits and losses from the business must be allocated based upon capital contributions from shareholders.

  • No More than 100 Owners. Owners also cannot be “non-resident aliens”, C corporations, LLCs, other S corporations, or non-qualified trusts. LLCs and C corporations do not have limits on the number of owners.

  • Increased Taxes.  Sole proprietors, partners, and employees owning more than 2% of an S corporation must pay taxes on the benefits such as group-term life insurance, medical reimbursement plans, medical insurance premiums, and parking.  In addition, a shareholder needs to receive reasonable compensation.

If you want to explore whether incorporating your business is right for you, contact the legal professionals in the UpCounsel marketplace. At UpCounsel, you'll find up-to-the-minute advice from top lawyers who average 14 years of legal experience. Our lawyers have provided legal services to successful enterprises such as Menlo Ventures and Google.  Talk to UpCounsel before you make a move.