Corporate Taxonomy

The most common types of corporations for new businesses are the “C” corporation, the “S” corporation and the “LLC.” We include the partnership as a cautionary tale. What follows is just an overview:

1. The “C” Corporation: This is what most (but not all) “big businesses” are, plus a lot of small businesses, though LLCs are fast becoming more popular. The actual owners (“shareholders”) of the corporation, which act through an elected board of directors, are legally separate from the management (the CEO, etc.), though it’s common for shareholders to be managers, especially in small corporations. There are a lot of corporate formalities that must be observed, such as shareholder meetings, regular meetings of the board, the taking of minutes of such meetings, and so forth. Dividends (distributions of profit to the shareholders) are taxed twice, once at the corporate level, and again at the individual level. But sales of stock is usually taxed as capital gains (which has a lower rate). Investors often insist on the formation of C corporations, with representation on the board of directors. There are a lot of traps for the unwary—as shown in this scene from The Social Network where Eduardo gets his early Facebook shares diluted.

2. The “S” Corporation: This can be thought of as the C corporation’s little brother—or as a midway stop between the LLC and the C corporation. It is for small companies whose shareholders are also employees. It has the formalities of a corporation, though they’re easier to deal with than the C corporation’s, and they’re subject to a bunch of IRS regulations, though not oppressively so. Like an LLC, they’re “pass through” entities; i.e. profits must pass through to the owners (shareholders in this case), either as a reasonable salary (complete with payroll taxes) or a dividend (if the salary isn’t enough), but without the C corporation’s double taxation. Control of the S corporation must track ownership; e.g., if you own 25% of the shares, you have a 25% say in how the company is run, and a right to 25% of the dividends.

3. The LLC (“Limited Liability Company”): This is also a “pass-through” entity, but the company’s profits pass through directly to the owners, without the need to pay salaries. However, the money is taxed at the individual level as self-employment income, which can be pretty high. At the level of the LLC, taxes are a whizz, since there’s hardly anything to report. LLCs are highly flexible. There need not be much in the way of formalities if you don’t want (though you can have ones you think are useful), and ownership and control need not coincide (so you can have a “silent partner” who has a right to, say, 30% of the profits but has little or no say in how the company is run).

4. The Partnership or Joint Venture: Outside some speciality fields, such as real estate, there really isn’t any reason to form a partnership. We include this category as a warning against one of the worst legal pitfalls ever: the unintentional partnership. You see, unlike the corporate entities, you needn’t do anything formal to create a partnership. You just need to need to work together and share profits proportionally. It can be an awkward moment when you realize that all that nice furniture you bought for your home office is partially owned by your buddies.