Entity Formation Basics: The C Corporation
Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.
This post is about the standard corporation, also called the “C corporation”.
The corporation is one of the oldest forms of business entity, with predecessors identified both in ancient Rome and ancient India. Complex societies needed a way to allow groups of people to form an independent body that had the right to own property, make contracts, sue and be sued, and perform various other legal acts.
Today, a corporation is defined as an independent legal entity that is owned by shareholders. A corporation can have just one shareholder or, as may be the case for a large publicly-traded company, millions of shareholders. Shareholders are protected from liability because the corporation, not the shareholders, is held legally liable for the actions and debts the business incurs.
While corporations are owned by shareholders, they are supposed to be managed by a Board of Directors and operated by officers (President, Secretary, Treasurer, CEO, etc.). If you are a smaller, closely-held corporation, the same individuals may serve in these different capacities, meaning one person might concurrently be a shareholder, a member of the Board, and the President. Understandably, this may get confusing! However, it is important to realize each role carries its own duties and responsibilities under the law. As such, understand the differences in these roles if you are hoping to create and operate a corporation of your own.
Today, maintaining a corporation tends to be more complex than other business structures because of various administrative, tax, and legal requirements, some of which are discussed here. If you are interested in forming a corporation, we strongly advise consulting with a business attorney who can help identify and prepare you for the many legal requirements and decisions you will run into (for example, do any of the founders need to make an 83(b) election?).
Forming a Corporation
A corporation is formed under the laws of the particular state in which it is registered. (Read our post on incorporating in Delaware here.)
To register, you need to file certain documents, typically Articles of Incorporation, with the Secretary of State office. The individual who actually files these formation documents is usually called the “Incorporator”.
Immediately upon filing the Articles of Incorporation, the corporation should identify its shareholders, and the shareholders should then elect the Board of Directors. Again, all major management decisions in a corporation are made by the Board, and one of the first management decisions should be to appoint officers, the individuals who can perform the necessary acts for the business to actually get off the ground (for example, opening a bank account, hiring employees, signing a lease, negotiating with vendors, etc.).
Taxation is often considered the most significant difference for small business owners when evaluating “C corporations” versus “S corporations” or other entity types. (For a discussion of S corporations, click here.)
Traditional C corporations are separately taxable entities with the IRS and nearly all state Departments of Revenue (corporate income tax rates range from 4% in North Carolina to 12% in Iowa). C corporations file a corporate tax return (Form 1120 for the IRS) and pay taxes at the corporate level. They then may face the possibility of double taxation if corporate income is distributed to the shareholders as dividends, because then tax is paid again at the individual Form 1040 level.
If you are a small business owner contemplating receiving regular payments from your company’s net profits, this double taxation issue could be very costly, and thus should be avoided.
So then why do so many companies accept double taxation and form a C corporation anyways?
C corporations have no restrictions on ownership. A shareholder can be an individual, another corporation, a trust, or any other type of legal entity. Also, a shareholder in a C corporation does not have to be a U.S. citizen or a U.S.-based entity as in some other entity types.
Probably the biggest reason however is that C corporations can have multiple classes of stock. This means a company can have “Class A” preferred stock with priority dividend payments, more voting rights, and a higher position on the priority ladder in the event of a liquidation or bankruptcy, and then “Class B” common stock that is lower-ranked and much more prevalent for equity financing, the process of raising capital through the sale of stock to outside investors.
Thus, if you are planning to seek venture capital or to go public one day, the C corporation is probably the better choice. VC firms prefer the familiar structure and management of a conventional corporation and are well-versed in Delaware corporate law. Similarly, many investment bankers insist a company be incorporated in Delaware before they take it public through an Initial Public Offering (IPO).
If you’re considering starting a business or revisiting a current one, contact us today.