The comedian Rodney Dangerfield once said, “My wife and I were happy for 20 years. Then we met.” All kidding aside, one of the most important decisions we will make in our personal lives is who will be our spouse or significant other. Likewise, one of the most important decisions you will make in the life of your business is which type of legal entity you create for your new business, be it an S corporation, a C corporation, a limited liability company or a partnership. It’s worth noting that your choice of legal entity will have a significant impact on many aspects of your business, including taxation, liability protection, management, financing, complexity, size, maintenance costs and flexibility.
C corporations can have multiple classes of stock, an unlimited number of shareholders of various types (i.e. entities and individuals) and provide liability protection to shareholders. C corporations are generally more complicated to maintain than limited liability companies (which may mean additional expense), but are more flexible than S corporations in several respects. C corporations are subject to double taxation, meaning the corporation pays tax on its corporate income, after which its shareholders also pay tax on any dividends received.
C corporations are generally well-suited for large or growing businesses with many shareholders, business that may go public and businesses that are likely to seek investment from sophisticated investors, like venture capital or private equity funds. Converting a C corporation to an LLC is a taxable event (i.e., taxable liquidation) which can have immediate and significant tax implications that should be evaluated by a tax professional. Converting a C corporation to an S corporation is not a taxable event but disposal of former C corporation assets by a converted S corporation may have tax implications and should also be evaluated by a tax professional.
S corporations can only have one class of stock (i.e. common stock), can have no more than 100 shareholders, can only have certain types of shareholders (i.e. individuals, certain trusts and estates), cannot be certain types of companies (i.e. certain financial institutions, insurance companies, etc.) and cannot have foreign shareholders. S corporations provide liability protection to shareholders, but are less flexible than C corporations and limited liability companies. S corporations can be more expensive and complicated to maintain than limited liability companies. Unlike C corporations, S corporations are not subject to double taxation. Instead, S corporations are pass-through tax entities, meaning that the S corporation’s income and losses are passed through to the shareholders for tax reporting.
S corporations are generally best-suited for small to medium-size businesses. One advantage of S corporations over LLCs is that income in S corporations is not subject to self-employment tax. Conversion of an S corporation to an LLC is treated as a taxable liquidation which may result in taxable gain to the shareholders. This may make conversion to an LLC impractical in some situations. Conversion of an S corporation to a C corporation is not a taxable event per se, but conversion subjects the corporation to double taxation as discussed above.
Limited Liability Companies
Limited liability companies (LLCs) are very popular. They can have multiple classes of membership interests (the LLC equivalent of stock), can have a large number of members of various types (i.e. entities and individuals) and can provide liability protection to members. There are fewer formalities associated with operating LLCs, and, as a result, LLCs are generally less expensive and complicated to maintain than corporations. LLCs are more flexible than corporations because LLCs can allocate profits and losses to the members disproportionately (i.e. not uniformly based on ownership percentages). Like S corporations, LLCs are pass-through entities for tax purposes.
If a business is likely to generate losses in its early years, an LLC would allow the members to deduct such losses (subject to certain limitations) from their taxable income. LLCs can also be converted to corporations later without adverse tax consequences, in most but not all cases.
Some Parting Thoughts
Whether you choose a C corporation, S corporation, or LLC for your new business, choose wisely! Your choice of legal entity could have a significant impact on the future success of your nascent business. Just as you would not want to make a long-term commitment to a spouse or significant other without first getting acquainted, you should not choose a business entity until you have thoroughly discussed the issue with your business attorney and accountant.
Alexander F. Kennedy is a business lawyer at the law firm of Jones Waldo Holbrook & McDonough PC in Salt Lake City. He can be reached at (801) 534-7224 or email@example.com. Alex wishes to thank his tax lawyer colleague, Bruce Babcock, for his assistance with this blog.