Many founders will consider a change in their respective company’s legal entity to be a monumental decision. Due to the potential ramifications associated with such change, founders of start-up businesses may be intimidated by the prospects of successfully transitioning from, for example, a limited liability company (“LLC”) to the standard corporation (“C-Corporation”). Fortunately, the flexible nature of each legal entity available to a particular company ensures that the entity formation process can organically adapt to the company’s shifting or expanding vision. For example, the economic features of an LLC may suitably fit the financial needs of an early stage start-up company. However, once sufficiently successful and expanded, the company may want the adopt the features of the C-Corporation to acquire venture capital financing. While the LLC may be a common entity option for early stage start-up businesses, there exists another common alternative: The S-Corporation. And, like the LLC, an S-Corporation may seek to become a C-Corporation in the future.

The focus of this blog post turns toward the S-Corporation and the C-Corporation. Section I discusses the similarities and differences of the S-Corporation and the C-Corporation. In the next post, Section II will highlight the steps required to successfully transition from the S-Corporation to the C-Corporation.

 

Section I. The Basics: The S-Corporation and the C-Corporation

Similarities: The Corporate Form

The S-Corporation and the C-Corporation are, first and foremost, corporations. That may sound completely obvious, but the implications of such a fundamental similarity affect the degree of complexity involved in the process of transitioning from an S-Corporation to a C-Corporation. Moreover, the characteristics shared by the S-Corporation and the C-Corporation arise from the standard corporate form. Those characteristics include the following:

  • The corporation’s shareholders are protected by limited liability (which means that a shareholder’s personal belongings and/or property cannot be seized by the corporation’s creditors—the parties to whom the corporation owes payment).
  • Ownership of the corporation belongs to the shareholders, not the board of directors or corporate managers.
  • The corporation issues stock to current and/or prospective shareholders.
  • The profits of the corporation can be distributed to the shareholders via dividends based on their respective shares.
  • The operations of the corporation are run by a board of directors and corporate managers.
  • The corporation and its members must adhere to corporate formalities, such as the attendance of shareholder and board meetings, the maintenance of minutes for the corporate meetings, and the submission of annual reports along with the associated annual fees.
  • Failure to adhere to the formalities of the corporation may result in the loss of personal liability protection.
  • Every corporation starts out as a C-Corporation.

Differences: The Corporate Status

The very last point in the prior list mentions that every corporation initially adopts the status of the C-Corporation. However, that status can change from the C-Corporation to the S-Corporation with the filing of one form to the Internal Revenue Service: Form 2553 (“Election by a Small Business Corporation”). Without the proper completion of Form 2553, the corporation will automatically remain as a C-Corporation. There exist several distinct differences, which are shown in the table below, between the S-Corporation and the C-Corporation that warrant the extra-step process through Form 2553.

The S-Corporation The C-Corporation
Pass-through taxation:

Shareholders are subjected to taxation, not the corporation (accordingly, no double taxation).

Double Taxation:

(1) The corporation will be taxed, and (2) the individual shareholder will be taxed only if the corporation’s profits are issued to the shareholders via dividends.

Shareholder Limits:

Limited to 100 shareholders who must be citizens or residents of the United States.

Shareholder Limits:

Not limited to 100 shareholders; shareholders are not restricted to only citizens or residents of the United States.

Class of Stock Limits:

Limited to only one class of stock.

Class of Stock Limits:

Not limited to one class of stock; multiple classes of stock (e.g., common stock and preferred stock) can be issued to shareholders.

Deduction of Fringe Benefits Costs:

The cost of fringe benefits (e.g., disability and health insurance) to shareholder-employees cannot be deducted.

Deduction of Fringe Benefits Costs:

The cost of fringe benefits (e.g., disability and health insurance) to shareholder-employees can be deducted.

Taxation of Fringe Benefits Costs:

Shareholder-employees whose ownership of the corporation exceeds two percent (2%) must pay taxes on the cost of fringe benefits (e.g., disability and health insurance).

Taxation of Fringe Benefits Costs:

Shareholder-employees are not taxed on the cost of fringe benefits (e.g., disability and health insurance) unless such benefits are given to less than 70% of the corporation’s employees.

Financing from Investors:

More restrictions on the number and types of shareholders and classes of stock are not favored by investors, such as venture capitalists.

Financing from Investors:

Less restrictions on the number and types of shareholders and classes of stock are favored by investors, such as venture capitalists.

Based on the information in the table above, every corporation can be a C-Corporation, but not every corporation can be an S-Corporation. Early stage start-up companies have the benefit of more easily meeting the eligibility requirements of the S-Corporation than later stage start-up companies. When considering whether to adopt the S-Corporation before the expected switch to the C-Corporation down the road, the founders of a start-up company should carefully consider the costs and benefits of both types of corporations.