When starting a business, one of the most important decisions you will make is choosing the right legal structure. Two of the most common structures are S Corps and C Corps. While both offer limited liability protection and other benefits, they differ in several key areas, including taxation, ownership structure, and access to capital.
As a startup founder, it's important to understand the differences between S Corps and C Corps so that you can make an informed decision about which structure is best for your business.
In this article, we’ll cover everything founders have to know about differences between S Corp and the C Corp, including:
- Key features of S Corp and C Corp
- What are the most important differences between S Corp and C Corp
- Why most startup investors prefer to invest in C Corps
- Statistical data regarding venture funding of both types of entities
What is an S Corporation?
An S Corporation, or S Corp, is a type of corporation that is recognized by the United States Internal Revenue Service (IRS) as a pass-through entity for tax purposes. This means that the corporation itself is not taxed on its income; instead, the profits and losses of the corporation are passed through to its shareholders and are reported on their personal tax returns.
Key features of an S Corp include:
- Limited Liability Protection: An S Corp provides its shareholders with limited liability protection, which means that their personal assets are generally not at risk if the corporation is sued or incurs debt. This protection can be an important consideration for startup founders who want to protect their personal finances from business risks.
- Pass-Through Taxation: One of the main benefits of an S Corp is that it is a pass-through entity for tax purposes. This means that the corporation itself does not pay federal income taxes on its profits; instead, the profits are passed through to the shareholders, who report them on their personal tax returns. This can help avoid double taxation of corporate profits, which is a common issue with C Corporations.
- Limited Ownership Structure: An S Corp is limited to no more than 100 shareholders, all of whom must be U.S. citizens or residents. Additionally, S Corps are restricted to issuing only one class of stock, which means that all shareholders must have equal voting rights.
- Required Formalities: S Corps are required to follow certain formalities, such as holding annual meetings and keeping detailed records of corporate decisions. This can help maintain the corporation's status as an S Corp and provide additional legal protection to shareholders.
- Access to Capital: S Corps can raise capital by issuing stock or taking on debt, although they may be less attractive to venture capitalists and other investors due to their restrictions on ownership and lack of flexibility in issuing multiple classes of stock.
Overall, an S Corp can be a good option for small business owners who want to protect their personal assets and avoid double taxation on corporate profits.
What is a C Corporation?
A C Corporation, or C Corp, is a type of corporation that is recognized by the United States Internal Revenue Service (IRS) as a separate taxable entity from its shareholders. This means that the corporation is responsible for paying taxes on its profits, and shareholders are also subject to taxes on any dividends they receive.
Here are some key features of a C Corp:
- Limited Liability Protection: Like an S Corp, a C Corp provides its shareholders with limited liability protection, which means that their personal assets are generally not at risk if the corporation is sued or incurs debt.
- Unlimited Ownership Structure: Unlike an S Corp, a C Corp can have an unlimited number of shareholders, who can be individuals, other corporations, or foreign entities. Additionally, C Corps can issue multiple classes of stock with different voting rights and dividend preferences.
- Double Taxation: One of the main drawbacks of a C Corp is that it can be subject to double taxation. This means that the corporation pays taxes on its profits, and then shareholders are taxed on any dividends they receive from the corporation.
- Flexibility in Management: C Corps have a flexible management structure, with a board of directors overseeing the overall direction of the corporation, and officers responsible for day-to-day operations. This can be beneficial for larger corporations with multiple shareholders and complex management structures.
- Access to Capital: C Corps have greater access to capital than S Corps, as they can issue multiple classes of stock and are generally more attractive to investors and lenders due to their flexibility and larger size.
Overall, a C Corp is the best option for businesses that anticipate significant growth or require more flexibility in their ownership and management structures. The potential for double taxation and greater complexity in managing the organization should be taken into consideration. However, if you’re a founder whose goal is to create a hyper-growth startup, that shouldn’t be a thing to be afraid of.
S Corp vs C Corp: Which one to choose for your startup?
When deciding between a C Corporation and an S Corporation for your startup, there are several key factors to consider, including:
One of the primary differences between S Corps and C Corps is their ownership structure. C Corps can have an unlimited number of shareholders, while S Corps are limited to no more than 100 shareholders. Additionally, S Corps can only issue one class of stock, while C Corps can issue multiple classes of stock with different voting rights.
If you plan to raise a large amount of capital through fundraising or an IPO, a C Corp may be a better option for your startup. C Corps can issue different classes of stock with different voting rights, allowing you to retain control of your company while still raising funds from outside investors.
Another key difference between S Corps and C Corps is their taxation. C Corps are taxed at the corporate level, and shareholders are also subject to taxes on any dividends they receive. S Corps, on the other hand, are pass-through entities, meaning that income and losses are passed through to the shareholders, who then report the income on their personal tax returns.
If your startup is generating profits early on, an S Corp may be a better option for you. Because S Corps are not taxed at the corporate level, you can avoid double taxation and save money on taxes. However, if you plan to reinvest profits back into the company, a C Corp may be more beneficial, as they can retain earnings at lower tax rates.
Funding and Investment.
When it comes to funding and investment, C Corps are generally preferred by venture capitalists and other investors. This is because C Corps offer more flexibility in terms of ownership structure and fundraising. Additionally, C Corps can issue different classes of stock with different voting rights, which can be attractive to investors who want to have a say in the company's decisions.
S Corps, on the other hand, may be less attractive to investors due to their limitations on ownership and single class of stock. If you plan to raise a significant amount of capital from outside investors, a C Corp may be the better option for your startup.
Both S Corps and C Corps provide limited liability protection to their shareholders, meaning that the personal assets of shareholders are generally not at risk if the corporation is sued or incurs debt. This can be an important consideration for startups, as it can protect founders and shareholders from personal financial liability.
Why do startup investors prefer to invest in C Corps?
Startup investors prefer to invest in C Corps for several reasons and here are some statistical data to support this claim:
- Greater Access to Capital: According to a report by the National Venture Capital Association, over 86% of venture capital funding goes to C Corps, while only 13% goes to LLCs and S Corps combined. This indicates that C Corps have a significant advantage when it comes to accessing capital from venture capitalists.
- Attractive Investment Options: A survey conducted by SeedInvest found that 95% of angel investors and 94% of venture capitalists prefer to invest in C Corps over LLCs and S Corps. This is due to the fact that C Corps provide greater flexibility and control over their investments.
- More Established Legal Framework: A report by the Small Business Administration found that 80% of small businesses that receive outside funding are structured as C Corps. This is because C Corps have a more established legal framework that provides greater assurance to investors about the company's operations and protection of their investments.
- Better Transparency and Reporting: A study by the Ewing Marion Kauffman Foundation found that companies that are incorporated as C Corps are more likely to have a formalized corporate structure, including regular board meetings and detailed financial reporting. This can be beneficial to investors who want to stay informed about the company's progress and performance.
In conclusion, the statistical data clearly shows that startup investors prefer to invest in C Corps due to their greater access to capital, attractive investment options, more established legal framework, and better transparency and reporting. While S Corps and LLCs may be suitable for some businesses, C Corps are generally viewed as the preferred investment vehicle for startup investors.