When establishing a business in the United States, entrepreneurs often face a pivotal decision between two primary corporate structures: the C corporation (C corp) and the S corporation (S corp). Both offer unique advantages and bear distinct differences, impacting everything from taxation to shareholder limits.
As entrepreneurs and business leaders consider the most beneficial structure for their enterprises, understanding these differences becomes paramount. The decision to operate as an S corp vs. C corp depends on the business’s goals and needs. Factors such as the desire to raise capital, plans for issuing stock, shareholder restrictions, and taxation preferences will influence this choice.
This article explains the nuances of S corps and C corps, shedding light on their characteristics to guide business owners toward an informed decision.
- While C corps are subject to double taxation—once at the corporate level and again at the individual shareholder level—S corps benefit from pass-through taxation, eliminating corporate taxes.
- S corps have stricter guidelines, limiting them to 100 shareholders and requiring all shareholders to be U.S. citizens or permanent residents, whereas C corps have more flexibility in ownership and shareholder count.
- Unlike C corps, which can issue multiple classes of stock, S corps can only issue one class, impacting potential investment strategies and equity distributions.
What Is an S Corp?
An S corporation (S corp) is a subchapter of the Internal Revenue Code that allows corporations to pass corporate income, deductions, credits, and losses through shareholders for federal tax purposes that meet Internal Revenue Service criteria.
S corporations are typically smaller, private companies. Many small to medium-sized businesses, professional groups (like doctors or lawyers), and family-owned businesses choose the S corp structure to take advantage of pass-through taxation benefits.
Here are some important points about S corporations:
1. Pass-Through Taxation
Unlike C corporations, which are subject to double taxation (once at the corporate level and once when dividends are distributed to shareholders), S corporations are not taxed at the corporate level. Instead, the income or losses of the S corporation pass through to its shareholders, and they report that income or loss on their personal tax returns. This can result in a single layer of federal tax.
2. Eligibility Criteria
Not every company can elect to be treated as an S corp. To qualify, a corporation must:
- Be a domestic corporation
- Have allowable shareholders, including individuals, certain trusts, and estates
- Not have more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (which includes certain investment companies, financial institutions, and insurance companies)
3. Shareholder Salaries and Distributions
Shareholders who work for the company are considered employees and must receive a “reasonable” salary, which is subject to federal employment taxes. Any additional profits can be distributed as dividends, which might be taxed at a lower rate than regular income.
4. State Taxation
While S corps avoid federal double taxation, some states may still impose taxes at the corporate level.
5. Liability Protection
S corps generally offer limited liability protection, which means that shareholders typically aren’t personally liable for corporate debts or liabilities.
An S corporation status can be terminated either voluntarily or involuntarily (if the corporation no longer meets the requirements). If terminated, the corporation might be prevented from electing S corporation status again for a certain number of years.
Filing as an S corporation provides businesses with a blend of corporate structure benefits and pass-through taxation. While shareholders of an S corp enjoy the limited liability protection characteristic of a corporation, the primary advantage lies in its tax treatment: S corporations are not subject to corporate income taxes. Instead, the company’s income, losses, deductions, and credits flow through to shareholders, who report this information on their individual tax returns.
What Is a C Corp?
A C corporation (C corp) is the standard corporation under the IRS code, specifically referred to as subchapter C of the Internal Revenue Code. C corps are the most common type of corporation in the U.S. and are distinct from S corporations in how they’re taxed and structured.
Most of the large, publicly traded companies in the U.S. are structured as C corporations because of their need for multiple classes of stock and the ability to have an unlimited number of shareholders. Examples of C corps include Apple Inc, Microsoft Corporation, Coca-Cola Company, and Amazon.com, Inc.
Here are the essential details of a C corporation:
1. Double Taxation
One of the most distinctive features of a C corp is the concept of double taxation. First, the corporation itself is taxed on its profits. Then, if those profits are distributed to shareholders as dividends, the shareholders also pay taxes on those dividends at their individual tax rates.
2. Liability Protection
Like S corporations, C corporations provide limited liability protection. This means the owners (shareholders) of the corporation are typically not personally responsible for the company’s debts or liabilities. Their financial responsibility is limited to their investment in the company’s stock.
3. Structure and Flexibility
C corps can have unlimited numbers of shareholders, and there’s no restriction on who can be a shareholder, unlike S corporations. They can also issue multiple classes of stock, such as preferred and common stock.
4. Perpetual Existence
C corporations continue to exist even if the owners or shareholders change or the owners die.
5. Potential Benefits for Employees
C corps can offer a wider range of fringe benefits to employees that are tax-deductible for the corporation and tax-free for the employees. Some examples of tax-deductible benefits include health care, retirement plan contributions, life insurance, educational assistance, and company cars.
6. Regulations and Formalities
C corps are subject to more regulations than other business structures, like sole proprietorships or LLCs. They’re required to have a board of directors, hold regular board meetings, keep detailed records, and file annual reports and other paperwork depending on the state of incorporation.
7. State Taxation
Depending on the state, C corporations may be subject to various state taxes, including franchise taxes and other corporate income taxes.
Filing as a C corporation offers several advantages, most notably the distinct separation between the company and its owners, which provides limited liability protection for shareholders’ personal assets. C corporations can also attract outside investors through the sale of stock, benefit from an expanded ability to deduct employee benefits, and have no restrictions on the number and type of shareholders.
S Corp vs. C Corp Similarities
Both S corps and C corps are types of corporations, and they share several characteristics and regulatory elements because they are both rooted in the corporate business structure.
Here are some of the similarities between the two:
- Formation Process: Both S corps and C corps are formed by filing Articles of Incorporation with the state’s Secretary of State or a similar state agency. The formation process typically requires payment of a filing fee and may involve other regulatory requirements.
- Limited Liability: Shareholders in both S corps and C corps enjoy limited liability protection. This means that their personal assets are generally protected from the debts and liabilities of the corporation.
- Corporate Formalities: Both S corps and C corps are required to follow certain corporate formalities. These might include:
- Adopting bylaws
- Issuing stock
- Holding annual meetings of directors and shareholders
- Keeping minutes of those meetings
- Maintaining separate bank accounts from the owners
- Perpetual Existence: Both types of corporations have a perpetual existence, meaning the corporation continues to exist even if the owners or shareholders change or the owners die.
- Management Structure: Both have a similar management structure that typically includes shareholders, directors, and officers.
- Shareholders are the owners who elect the board of directors.
- The board of directors makes high-level decisions and sets company policies.
- Officers (like the CEO and CFO) handle the day-to-day operations.
- Stock: Both S corps and C corps have the ability to issue stock, though the specifics (like classes of stock and stockholder eligibility) can vary.
- Regulation and Reporting: Both types of corporations are subject to state-specific regulations, and they may be required to file annual reports, pay annual fees, and meet other regulatory requirements depending on the state of incorporation.
- Employment Taxes: For shareholders who are also employees of the corporation (common in many small corporations), both S corps and C corps must pay employment taxes on wages or salaries paid to these shareholder-employees.
S corps and C corps are both types of corporate business structures that provide limited liability protection to their owners, but they differ in taxation and ownership rules. Both are separate legal entities created under state law and subject to certain formalities like filing Articles of Incorporation and holding annual meetings.
S Corp vs. C Corp Differences
While S corporations and C corporations share a number of similarities because they both fall under the broader category of corporations, they also have several key differences, especially in terms of taxation and ownership structures.
Here are some of the main differences between an S corp and C corp:
C corp: C corps are subject to double taxation, which means that the corporation pays taxes on its profits at the corporate tax rate. Then, if profits are distributed to shareholders as dividends, those dividends are also taxed at the individual shareholder’s tax rate.
S corp: S corps are typically not subject to federal double taxation. Instead, it’s a pass-through entity, meaning the corporation itself doesn’t pay federal income taxes. Profits and losses are passed directly to shareholders and are reported on their individual tax returns.
2. Shareholder Restrictions
C corp: C corps can have an unlimited number of shareholders and can also have non-U.S. citizens or residents as shareholders. They can also have other corporations, partnerships, or LLCs as shareholders.
S corp: S corps can have a maximum of 100 shareholders. All shareholders must be U.S. citizens or residents, and they cannot be other corporations or partnerships.
3. Stock Classes
C corp: C corporations can issue multiple classes of stock, such as common and preferred stock.
S corp: S corporations can only have one class of stock, though they can have both voting and non-voting shares.
4. Tax Deductions and Benefits
C corp: C corps can offer a wider range of fringe benefits that are deductible by the corporation and tax-free for employees.
S corp: For S corps, the range of tax-free benefits for employees who are also shareholders is more limited.
5. State Taxation
C corp: C corps are usually taxed at the state level.
S corp: While S corps avoid the federal double taxation, some states may still tax S corps at the corporate level or recognize them differently for state tax purposes.
C corp: By default, when businesses incorporate, they’re considered a C corp by the IRS unless they elect otherwise.
S corp: To be considered an S corp, a corporation must meet specific IRS criteria and file an election (Form 2553).
C corp to S corp: C corps can elect to convert to S corps by meeting eligibility criteria and filing the appropriate paperwork with the IRS. There may be tax consequences for making the conversion.
S corp to C corp: S corps can revoke their S status and become a C corp. Again, this decision may have tax implications.
The primary difference between a C corp and an S corp is their taxation structure.
C corps are taxed as separate entities and can face double taxation (once at the corporate level and again at the shareholder level on dividends), while S corps have pass-through taxation, allowing profits and losses to be reported directly on shareholders’ personal tax returns, avoiding corporate-level taxation.
Which Entity Is Right for You?
Choosing between a C corp or an S corp for your business involves evaluating several factors based on your business’s specific needs and goals.
Here’s a brief guideline:
- Tax Considerations: One of the most distinguishing differences is taxation. C corps are subject to double taxation (at the corporate and then shareholder level when dividends are distributed), while S corps enjoy pass-through taxation, where the corporation itself isn’t taxed, but the income flows through to the shareholders’ personal tax returns. If avoiding double taxation is a priority, an S corp might be preferable.
- Ownership Restrictions: S corps have ownership restrictions. They can’t have more than 100 shareholders, and all shareholders must be U.S. citizens or residents. Plus, S corps cannot be owned by C corps, other S corps, LLCs, partnerships, or certain trusts. If your business anticipates diverse or international ownership, or if you plan to have more than 100 shareholders, a C corp would be necessary.
- Stock Classes: S corps can only issue one class of stock (though there can be differences in voting rights), while C corps can issue multiple classes. If you’re considering venture capital or want flexibility in stock offerings, a C corp might be better.
- Employee Benefits: C corps have an advantage in terms of deductibility of fringe benefits. If offering a robust benefits package is part of your business model, especially for owner-employees, a C corp might be more advantageous.
- Growth and Future Intentions: If you intend to take your company public or seek venture capital, C corps are the standard choice, as they’re more familiar and flexible for these types of growth strategies.
- Ease of Transfer: Shares in a C corp can be freely traded or transferred, while S corp shares have limitations due to their ownership restrictions. If you plan to trade shares freely, a C corp may be right for you.
- State-Level Taxation: While the federal tax distinctions between C and S corps are clear, state-level treatment can vary. Some states do not recognize the S corp designation and will tax it like a C corp. Research state-specific implications to learn if this affects your specific business.
- Administrative Complexity: S corps, because of their restrictions and pass-through tax nature, might sometimes have slightly less administrative complexity than C corps. If you are opening a small business or one with few employees for handling administrative tasks, an S corp may be the best choice.
There are, of course, other business entities to choose from when you are starting your own company. The goal in choosing your business entity is to save the most money possible on taxes and separate the business from yourself as a means of protection.
To learn more about your options, in addition to a corporation, read this article next:
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