Selecting the right type of incorporation for your startup is a crucial decision that can significantly impact your business’s future growth and success. In the United States, the most common types of business entities are sole proprietorship, partnership, Limited Liability Company (LLC), S Corporation (S-Corp), and C Corporation (C-Corp). Each comes with its own set of rules, regulations, and tax implications, making it essential for founders to consider their business needs, long-term goals, and potential investment opportunities when choosing the appropriate structure. However, in the realm of high-growth, venture-funded startups, the C-Corp reigns supreme. This article explains five reasons why most U.S. startups incorporate as C-Corps.
In the realm of venture-funded startups, the C-Corp reigns supreme.
1. Access to Funding
The number-one reason why most high-growth startups incorporate as C-Corps is investment. In fact, most venture capitalists will only invest in C-Corps. Why? To start with, most VC firms can’t legally be shareholders in an S-Corp. According to regulations, S-Corp shareholders must be U.S. citizens or residents and “natural persons”. This excludes other corporations like venture capital firms, as well as any non-resident foreign investors. For most startups, pursuing venture capital and other forms of institutional investment is reason alone to incorporate as a C-Corp.
To start with, most VC firms can’t legally be shareholders in an S-Corp.
2. Investor-Friendly Taxation
C-Corporations are also exceptionally attractive to investors from a taxation standpoint due to their unique structure which provides a high degree of flexibility in profit-sharing. While profits in other types of business structures are subject to pass-through taxation, meaning they are taxed at the individual owner’s tax rate, C-Corps are taxed at the corporate level. This allows for sophisticated profit-sharing mechanisms such as dividends, which are not subject to self-employment taxes. Moreover, investors in C-Corps can benefit from capital gains if they sell their shares at a profit. These features make C-Corps an appealing option for venture capitalists and other investors seeking a tax-efficient investment vehicle.
3. Limited Liability
Another one of the main attractions of a C-Corp is the personal liability protection it offers. In a C-Corp, the personal assets of shareholders, directors, and officers are shielded from business debts and lawsuits. This means if the company runs into financial troubles or legal issues, personal assets like a home or car are not at risk.
In a C-Corp, the personal assets of shareholders, directors, and officers are shielded from business debts and lawsuits.
Consider a scenario where a C-Corp called “TechVenture” is sued for patent infringement by a rival company. The lawsuit claims damages of several million dollars. As TechVenture is incorporated as a C-Corp, its shareholders, who are not directly involved in the litigation, are protected. That means, even if TechVenture loses the lawsuit and is required to pay the damages, the personal assets of the shareholders (like personal bank accounts, houses, or cars) are not at risk. The corporation’s assets are the only ones that could be used to settle such business debts. This distinct separation of personal and business assets is a primary advantage of C-Corp structure, offering peace of mind to the shareholders.
4. No Cap on Shareholders
Unlike other business entity types, such as S-Corps which cannot have more than 100 shareholders, C-Corps have no restrictions on the number of shareholders. This is important for startups that plan to go public or attract a large amount of investors.
5. Preferred Stock
A final key difference between C-Corps and S-Corps lies in the type of stock they can issue. C-Corps have the flexibility to issue both common and preferred stock. Preferred stock grants the stockholder certain advantages, such as priority dividends and preferential treatment in the event of liquidation. On the other hand, S-Corps are limited to issuing common stock. This restriction is part of the IRS requirements for S-Corps, which also include a limit on the number of shareholders and restrictions on who can be a shareholder. VCs who take a significant financial risk investing in your startup will almost certainly expect preferred stock, making this another compelling reason for high-growth startups to incorporate as C-Corps.
The benefits of incorporating as a C-Corp are clear from the list above. However, startup founders should be aware that owning a C-Corp also comes with additional management overhead and responsibilities that must be taken seriously. A C-Corp is a fully legal entity that is responsible for issuing annual reports, appointing a board of directors, and of course paying corporate taxes. It might seem like overkill when you’re first starting out, but if you plan to raise capital, incorporating as a C-Corp from the beginning is almost always the way to go.
FAQs
Unlike other business entity types, such as S-Corps which cannot have more than 100 shareholders, C-Corps have no restrictions on the number of shareholders. This is important for startups that plan to go public or attract a large amount of investors.
Why do investors prefer C-Corps? ›
In addition to strong liability protection, venture capitalists and other institutional investors prefer Delaware C-Corps because they provide more flexibility in corporate governance. Compared to other entity types, a Delaware C-Corp can more easily transfer shares of its corporate stock.
Why C-corp is better than S corp? ›
C-corps are desirable because there's no restriction on who can own shares. Other businesses and entities both in and outside the United States can hold ownership of a C-corp. There is also no limit to the total number of shareholders.
Why is C-corp better than LLC? ›
However, C-corps may offer more tax benefits in the long run. While LLCs are pass-through entities where profits and losses pass to the owners' personal returns, C-corps allow business losses to offset income earned. C-corps can also potentially qualify for more business tax deductions.
Why are most startups C Corps? ›
Access to Funding
The number-one reason why most high-growth startups incorporate as C-Corps is investment. In fact, most venture capitalists will only invest in C-Corps.
Why do VCs not like LLCs? ›
Investors do not like the tax implications of an LLC because as a partner, they'll be taxed on the entity's income even in years when no cash is distributed to them personally. VCs often avoid this structure as they don't want business profits or losses passing through to them directly.
What is the main disadvantage of a C corporation? ›
Disadvantages of a C Corporation
Double taxation. It's inevitable as revenue is taxed at the company level and again as shareholder dividends. Expensive to start. There are a lot of fees that come with filing the Articles of Incorporation.
Do C corp owners have to take a salary? ›
With a C corporation, you're not required to pay yourself a reasonable salary. In an S corporation, you are.
What is a disadvantage of an S corp? ›
Because of the one-class-of-stock restriction, an S corporation cannot allocate losses or income to specific shareholders. Allocation of income and loss is governed by stock ownership, unlike partnerships or LLCs taxed as partnerships where the allocation can be set in the partnership agreement or operating agreement.
When to switch from LLC to C corp? ›
LLCs offer flexibility and help simplify taxation and maintenance requirements, but if you are looking to raise money through investors or plan to take your company public, then a C Corp may be the best path to follow. Changing your LLC to a C Corp is a big step for any business owner.
C corporations, the most prevalent of corporations, are also subject to corporate income taxation. The taxing of profits from the business is at both corporate and personal levels, creating a double taxation situation.
Am I personally liable for the debt of a C corporation? ›
C corporations provide limited liability protection to owners, who are called shareholders, meaning owners are typically not personally responsible for business debts and liabilities.
Why choose C corp over S corp? ›
Taxation under Subchapter C will result in lower taxes than taxation under Subchapter S. Distributions will not be made to shareholders. You plan on an IPO or seeking investors not allowed for an S corporation. You want shares to be freely transferable.
Can C corp have one owner? ›
A C corporation is the same status that Fortune 500 businesses hold—they are corporate entities separate from their owners. In the case of an individually owned C corp, you are not just the owner of your company, but the majority shareholder as well.
What happens to C corp when the owner dies? ›
Unlike sole proprietorships, corporations or S corporations do not automatically cease to exist when a business owner dies; instead, the estate becomes the new owner of the business.
Why do investors like benefit corporations? ›
A benefit corporation is a legal tool to create a solid foundation for long term mission alignment and value creation. It protects company missions through capital raises and leadership changes. Benefit corporation structure creates more flexibility when evaluating potential sale and liquidity options.
Why do investors not want S corp? ›
Stock ownership restrictions.
An S corporation can have only one class of stock, although it can have both voting and non-voting shares. Therefore, there can't be different classes of investors who are entitled to different dividends or distribution rights.
Why are corporations attractive to investors? ›
A corporation is a separate legal and tax entity from its owners. It provides the most personal liability protection for owners/investors (shareholders), directors, officers, and employees. C Corporations can issue several types of stock to raise capital, and they may have an unlimited number of shareholders.
Do investors prefer LLC or S corp? ›
Advantages of S corps over LLCs
It can be easier to obtain outside funding as some investors and banks prefer to invest in corporations than LLCs because corporations are generally better for recapitalizing and reorganizing over time as a business grows.
