When It Makes Sense to Form a C-Corporation
The decision to form a C-corporation, rather than an LLC or S-corporation, should be based on a clear understanding of both the benefits and the tradeoffs. Under Subchapter C of the Internal Revenue Code (§§ 301–385), C-corporations are separate taxable entities. They pay corporate income tax at a flat 21 percent rate under § 11(b)(1), and shareholders are taxed again when dividends are distributed. This so-called “double taxation” often makes business owners reluctant to adopt the C-corporation form. Yet there are circumstances where a C-corp is the superior choice.
One common situation is where the business intends to raise institutional venture capital. Most venture capital firms and angel investors prefer to invest in C-corporations, particularly Delaware C-corps, because of the flexibility of corporate stock structures, liquidation preferences, and governance rules. In addition, only C-corporations can issue incentive stock options (ISOs) under IRC § 422, which are highly favored for compensating employees in the startup world. LLC equity compensation structures, by contrast, often create immediate taxable events for employees.
C-corporations also provide significant fringe benefit opportunities. Under IRC §§ 105 and 125, corporations can provide health plans, cafeteria plans, and medical reimbursements in ways that LLC members and S-corp shareholders cannot fully utilize. For owners who want robust benefit packages, the C-corporation can be more efficient.
Another powerful incentive is the Qualified Small Business Stock (QSBS) exclusion under IRC § 1202. If stock in a qualified C-corporation is held for more than five years, up to 100 percent of the gain on sale can be excluded from federal income tax, subject to limitations. This makes C-corp status highly attractive for founders planning an eventual exit.
That said, the C-corporation form does come with risks. Minority shareholders may feel disadvantaged by dividend taxation, and the flexibility of allocating losses in a partnership or S-corp is lost. Distributions are taxed again at the shareholder level, generally at 20 percent for qualified dividends, plus 3.8 percent if subject to the net investment income tax under § 1411. Furthermore, C-corps must observe corporate formalities, maintain board minutes, and comply with state and federal filing requirements.
Ultimately, the C-corporation is not always the default choice, but when raising institutional capital, planning for equity compensation, or targeting long-term growth with a potential stock exit, the C-corporation can provide unmatched advantages that outweigh its costs.
