A corporation is a legal structure preferred by venture capitalists, angel investors or others looking to invest substantial capital in a new or emerging company. If the company conducts considerable amounts of business nationwide and even internationally, its intricate operating structure will need an appropriate bureaucratic overlay to adequately manage its varied operations. A corporation is the most complex of the for-profit business organizations. In that sense, a new company that is growing into operational efficiency may find it more feasible to start with a partnership or LLC and see whether future success justifies transformation to a corporate conglomerate. Importantly, certain tax choices must be made when the business formation process begins.
You may have heard it said that the corporate legal structure suffers from the method of taxation known as double taxation. In the less complex business structures, such as the partnership and the LLC, the partners or members pay taxes only once and this occurs on their personal income tax return. The income from the business is “passed through” to the individual’s personal return without that income first being taxed by the IRS at the business level. Thus, with the sole proprietorship, the partnership, and the LLC, each of these entities is not taxed on income coming into the business and then to the individual on his or her personal return. Instead, the income of the business is subject to one tax only.
The C-Corp Method of Taxation Applies by Default
By contrast, the C-corporation (C-corp) is taxed by its earnings at the corporate level when it files an applicable corporation tax return. The profits then get distributed to the shareholders, usually in the form of dividends, which are reportable on the shareholder’s personal income tax return, thus making the same funds twice liable for income taxes, on the corporate and on the personal individual level. The IRS assigns the newly filed corporate entity a C-corporation tax status by default. The C-corp, therefore, represents the classic double-taxation practice that shareholders try to avoid where possible.
S-Corp Status Offers Advantages for Smaller Corporations
For companies with one hundred (100) or fewer shareholders that have no intentions of going public anytime soon, electing S-Corporation (S-corp) status is available pursuant to Subchapter S of the Internal Revenue Code. An S-corp is not subjected to double taxation. Instead, each shareholder reports corporate income on his or her personal income tax return but the S-corp does not pay income tax at the business level. The S-corp thus provides the same kind of pass-through tax method enjoyed by the proprietorship, the general partnership, and the LLC.
Other conditions apply for S-corp status. For example, the S-corp cannot have a non-resident alien as a shareholder. It cannot issue more than one class of stock and is limited in the amount of capital that it can raise. If qualified, the S-corp may operate with fewer formalities than the C-corp. The C-corp does have certain advantages over the S-corp. It can accept foreign investors legally and is thus a stronger investment vehicle. It is not limited in the number of shareholders, the classes of stock issued, or the amount of capital invested. It is the model that must be used when transforming to a public offering.
What Is A Close Corporation and How Can It Help?
If the company has a relatively few shareholders (owners) and is restricted to a limited group of investors, or where it consists of only one, two or a few shareholders, it may file and organize itself as a “close” corporation. The entity can be both an S-corp. and a close corporation. The shareholders must agree unanimously to be organized as a statutory close corporation pursuant to Maryland law. For example, where the company intends no public offering at any time soon and it will be owned by a relatively small number of shareholders, the owners may set it up as a “close” corporation, while also electing to be taxed as an S-corp.
2017 Maryland Code, Title 4, is the statutory provision that authorizes the creation of a close corporation by the shareholders. After formation, the close corporation’s shareholders can agree to abolish the board of directors and operate the company themselves. Maryland law specifically requires that the stock shares and certain other business forms, such as the articles of incorporation, must indicate clearly that the company has been organized as a close corporation and that restrictions are applicable.
One important restriction of a close corporation is that the shares of stock must be first offered to the existing owners and to the corporation prior to marketing them to the public. Remember that the S-corp is different than a close corporation although the two concepts share some similar characteristics. The S-corp refers to a method of taxation as does the C-corp. A close corporation serves different purposes and follows the Maryland statutory mandates.
Some of the foregoing issues are complicated by exceptions, qualifications, and numerous considerations under federal and Maryland law. A business law attorney and a tax consultant are the two main professionals that will guide you through the complexities of business organizations. An attorney can also help if the company has chosen S-corp status and wants to switch back to C-corp status. The S-corp election is made on IRS Form 2553, which all stockholders must sign, and the form must be filed with the IRS.
If you need advice regarding any business formation issue, please contact Maryland business law attorney Elsa W. Smith at the Law Offices of Elsa W. Smith, LLC. We have two offices to serve you: Annapolis and Laurel. You may also contact us via our website.