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When to Form a C Corporation

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The corporation is the structure of choice for growth companies. Growth companies will often times need to invest large sums of money on research and development. They create losses, which are a great tax shelter for future profits called “net operating losses” that can carry forward from year to year. If there are profits, they will likely be reinvested in the business, so distribution of profits to the owners does not usually occur. Consider Microsoft, which only declared and paid a dividend to its stockholders decades after the business was formed and only when it had billions of dollars in the bank.

There are two circumstances that will almost always militate in favor of forming a corporation instead of a LLC:

▪   You plan to raise money from outside investors. Investors tend to prefer investing in corporations. One of the principal reasons is that corporate law, the rights and obligations of stockholders and directors and the terms of investment documentation are fairly standardized in corporations. Investors want to have standardized terms across their portfolio of investments. This is especially true of venture capital funds, which will always want to invest in corporations. In addition, if you plan to raise funds through an equity-based crowdfunding transaction, you will most certainly want to be structured as a corporation in order to avoid having to prepare and send K-1s to scores, and hundreds or thousands of investors on an annual basis.

▪   You plan to use equity incentives to compensate employees and contractors. If you want to grant compensatory stock options to employees, the Internal Revenue Code provides special tax treatment called “incentive stock options” that only apply to shares of stock of a corporation. In addition, the corporation does not have to redo its formative documents each time an option is granted.

In short, the corporate structure is best suited for growth companies that intend to add new owners from time to time, whether through investment or equity compensation. The downside to a C corporation is that it is a separate taxpayer that must pay tax on the profits of the business prior to distributing profits to the owners of the business (which are then taxable to the stockholders as dividend income). This is called the “double tax”, which is less well suited for business that will produce profits that it intends to distribute to its owners.

Reprint by permission.

About the author: Bo Sartain

Bo is a practicing corporate attorney with the law firm of Haynes and Boone, LLP.  Bo’s legal practice focuses on the representation of investors and issuers in company formation, private equity and venture capital preferred stock and preferred LLC membership interest equity financings, and the representation of buyers and sellers in mergers and acquisitions. Formerly, Bo was a Systems Engineer and the founder and CEO of a startup software-as-a-service company.

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