Entity Selection Series - Part 2, C Corporations

Welcome back to the next part of our series on entity selection! 

Last week we talked about the pros and cons of LLCs and why you might choose to form an LLC within your business or as part of your acquisition structure. 

One question that gets presented frequently is whether a potential business buyer or new founder should start their company as an LLC or, instead, form their company as a C Corporation. 

The answer is almost always the same.....

So lets take a closer look at why someone might want to form a state corporation instead of an LLC.

Pros and Cons, the Legal Analysis

Every state in the union has it's own corporate form. Beginning in the 19th century, states adopted general incorporation statutes that replaced special legislative charters and enabled entrepreneurs to form corporations through standardized statutory procedures. These statutes established the core structural features of the corporate form including:

• separate legal personality,
• centralized management under a board of directors, limited liability for shareholders, and
• freely transferable ownership interests

Over time, state corporate law evolved through judicial decisions (notably in Delaware) and statutory reforms aimed at balancing investor protection with managerial flexibility, promoting capital formation, and encouraging economic development.

Modern state corporate codes such as the Delaware General Corporation Law (DGCL), provide a comprehensive governance framework governing formation, fiduciary duties, shareholder rights, capital structure, and merger transactions.

Their policy objective is to create a predictable legal environment that facilitates investment and risk-taking while imposing sufficient oversight to protect shareholders and other stakeholders.

These regimes coexist with federal securities laws, which regulate capital markets and disclosure obligations, creating a dual system in which states define the internal governance architecture of the corporation while federal law oversees public market integrity. 

Advantages of Corporations

The most significant advantage of a state corporation is predictability. Given how long corporations have existed in legal doctrine, how they function, how owners deal with disputes, how shareholder rights are protected are well defined. 

And there is comfort in predictability. So a state corporation could make sense in a number of situations.

The most basic use case is when raising capital. Almost every start-up that is looking to take on venture capital or angel investors will be required to have a Delaware based Corporation.

Corporations can also be an entity of choice when the owners are looking to heavily reinvest in the business. As discussed more broadly below, corporations are going to be taxed at a fixed 21%, as compared to pass-thru entities where the owner is taxed on all income regardless of whether or not they have cash distributions. 

Disadvantages of Corporations

While there are some clear upsides to corporations, the most significant downside is their lack of flexibility. 

As a general rule of thumb, corporations impose more rigid formalities compared to LLCs. These can include items such as mandatory boards of directors, annual meetings, and prescribed shareholder voting requirements.

These obligations increase administrative overhead and can expose closely held businesses to disputes if governance is not meticulously maintained, this can especially be true in cases where there is outside investors involved that can effectively co-opt the company if the owners aren't following the law.

This can sit in contrast to LLCs, which offer far more contractual flexibility, allowing owners to customize management rights, distribution mechanics, and fiduciary duties without the statutory rigidity that corporations require. 

Taxation of Corporations

Corporations have the option to be taxed in one of two ways: under Subchapter C as "C corporations" or under Subchapter S as "S Corporations"

C Corporations

As a baby tax lawyer, one of the very first classes I ever had to take was Corporate Tax. In it, our professor introduced to the fact that all corporations, every. single. one. is going to be subject to double taxation. 

So from the very start of my career, I was primed to think that double taxation is bad. 

Ultimately though Corporations are taxed under a principle that is foundational to the U.S. tax system. Where it rests is in the idea that Corporations are viewed as a taxpayer separate from it's owners. Previously corporations were taxed at much higher rates, almost 35% in many instances.

These days though, the corporate income tax flat is a flat rate of 21%. Because the corporation is treated as a separate taxpaying entity, owners are not taxed on corporate profits until those profits are distributed. This structure provides clarity and facilitates retained earnings for reinvestment, but it also creates the possibility of double taxation: once at the corporate level and again when dividends are paid to shareholders.

S Corporations

So lets get this out of the way right now, THERE IS NO SUCH THING AS AN S CORPORATION!

S Corporations are a tax-election. That's it. 

Okay so now that's out of the way, let's talk about how they are taxed:

Unlike C Corporations, entities taxed as S Corporations are "pass-thru" entities, meaning that all income, losses, deductions, and credits flow directly to shareholders, who report those items on their individual returns in proportion to their shareholdings.

This eliminates entity-level tax and avoids the double-tax regime of C-corps.

However, the S corporations carries strict eligibility rules limiting shareholders to U.S. individuals and certain trusts, permitting only a single class of stock, and requiring pro-rata allocations that may not reflect the economic reality desired by the owners. As a result, the S-election, while tax-advantaged, imposes operational constraints that can become burdensome as a company grows or brings in outside investors. Moreover, S corporations are not great vehicles for offering equity in the company to employees and buyers almost always dislike S Corporation targets and will likely require an asset sale.

Qualified Small Business Stock (QSBS)

If you are starting to think about buying an SMB, C Corporations have another advantage, the Qualified Small Business Stock exclusion (QSBS). QSBS allows eligible shareholders to exclude up to 100% of their capital gains, up to $15Mm, on the sale of qualified small business stock.

For founders, early employees, and investors, QSBS can materially reduce or eliminate tax on a successful exit. By design, this incentive promotes investment in high-growth domestic companies, making the C-corporation structure particularly attractive for businesses anticipating large equity appreciation or venture-style capitalization.

The corporate tax system therefore creates a strategic decision point for business owners: whether to accept the C-corporation’s double-tax exposure in exchange for access to QSBS and flexible capital structuring, or to pursue S-corporation pass-through treatment with its attendant eligibility restrictions. Each choice carries implications for fundraising, compensation planning, reinvestment strategy, and long-term exit opportunities. 

What Should You Do?

The corporate tax system therefore creates a strategic decision point for business owners: whether to accept the C-corporation’s double-tax exposure in exchange for access to QSBS and flexible capital structuring, or to pursue S-corporation pass-through treatment with its attendant eligibility restrictions. 

Depending on the reason you are starting your company there are a number of key questions a new owner should be asking as they evaluate whether C Corp taxation is right for them:

• Capital Strategy: Will the business raise angel, venture, or institutional capital that expects a corporate structure?

• QSBS Eligibility: Is there an expectation of an exit in the next 5-7 years? What is your growth strategy?

• Profit Use: Will the company primarily reinvest earnings, service debt, provide preferred returns for certain investors (favoring a C-corp) or distribute profits annually (favoring pass-through treatment)?

• Equity Compensation: Will the business recruit employees using stock options, RSUs, or other incentive equity tools best suited to the corporate form?

• Regulatory Requirements: Does the industry impose licensing, compliance, or oversight expectations that favor or require corporate governance?

Up on Deck: Parnterships

These first few emails are heavy, I'm not going to sugar coat it, but entity formation is a topic that is incredibly critical for business owners looking to start, grow, and exit their businesses. Failing to take into consideration key considerations can be significantly impact a business in the long term.

Next week I will be off for Thanksgiving. But we will be back in two weeks to talk about the final entity type in this series, Partnerships. Specifically, I will focus in on General Partnerships and Limited Partnerships. 

Happy Thanksgiving, I hope that you take this time to be present with your family making memories that will last a lifetime.

To your success,

Josh