The most frequently asked question is, “Which type of business should I form? C corporation or S corporation?”
There are some factors to consider before you answer this question.
What is C Corp?
A-C Corporation is a regular type of corporation. Its stock can be sold publicly, on an exchange, or through a private sale.
Unlike most corporations, the number of shareholders that can own c corp stock is unlimited. A-C Corp usually has many owners, so it needs to hold annual meetings and elect them by its shareholders (owners).
C Corp’s are also known as ‘regular corporations’ and “Class C Corporations.”
What is S Corp?
An S Corporation is a corporation taxed in the same way that partnerships or sole proprietorships are. It combines elements of both types of entities. Unlike a regular corporation, an S Corporation can have no more than 100 shareholders.
S corporations can shield their owners from personal liability for most types of corporate debts and legal actions. This means that if a company is sued, only its assets are used to pay the judgment against them, not its shareholder’s personal assets.
What Are the Differences Between an S-Corp vs. C-Corp?
There are many differences to consider when choosing between a C Corp vs. S Corporation, and you should be aware of each of them.
Here is a list of the most important factors:
C Corps are formed under state law, while The IRS creates s Corps through their own corporate laws.
For an S Corp to be formed, a business must pass specific tests that show it is not attempting to avoid federal and state tax obligations. So if a new corporation wants to be classified as an S Corp or convert from a regular corporation (C Corp) to an S Corporation status, a special application has to be filed with the IRS for approval.
C Corps are subjected to double taxation. They pay taxes at the state and local level and on the federal level in a manner similar to partnerships and sole proprietorship. C Corporations file their tax returns every year using Form 1120.
S Corps are only subject to tax once upon distribution of earnings to shareholders. S Corp tax filings take place every year using Form 1120S, and shareholders are responsible for paying their income tax on the earnings they receive from the company.
S-Corp vs. C-Corp Tax Example
As an example, to demonstrate the differences between double taxation on C Corp returns vs. single taxation on S Corp returns, let’s assume that your company made a PROFIT of $100,000 in 2015.
C-Corp Taxes: Your company would have to pay 35% tax ($35k) at the corporate level using Form 1120, and then the shareholders would also have to pay personal taxes on their individual income using Form 1040
S-Corp Taxes: Your company would only pay 25% tax ($25k) at the corporate level using Form 1120S since the 35% federal C Corp tax has already been paid. Then the shareholders would only have to pay personal income taxes on the earnings they received from the company, which is generally at a lower rate than the C Corp tax rate.
C Corporations have an unlimited number of shareholders and are generally owned by a group of people or individuals.
There is a maximum number of shareholders for an S Corp, which is 100. An S Corp’s stock can only be held by individuals (or certain types of trusts) who are US Citizens or residents. Most small businesses only have a few S corporation owners, so they are able to set up shop as an S Corp.
4.Annual Filing Requirements
An s corporation (S corp) is a lot like a partnership on paper. It has to file a special form each year with the IRS in addition to its tax return. This form is called Form 1120S, and you must file it if your company’s Total Revenue was $250,000 or more in the previous tax year.
This annual return does not add any extra cost for filing an s corp tax return – it is just a requirement that C Corp business owners should keep in mind.
In contrast, a C Corp files its tax returns using Form 1120 every year.
If you are starting a new company, the IRS requires that an S-Corp must be formed by the last day of the second month after your business starts. This may seem difficult, but I’d recommend talking to a business attorney for help with this process and making sure you start on time!
5. State Requirements for S-Corp vs. C-Corps
In addition to the IRS’s requirements, there are some state-level requirements that you need to follow when setting up an s corporation (S corp).
You’ll have to file a certificate of incorporation with your Secretary of State within 90 days after the tax year ends. This is also an important consideration for new S corp owners because the state requirements may differ from federal ones.
C Corp does not have any such requirements at the state level.
6. S Corp or C Corporations – Fill Out Form 2553
If you are starting a business that does not need to raise outside capital and you are not planning to sell the company, you should set up an S Corp.
If you plan to raise outside capital or sell your company within a few years, the IRS may consider you a C Corp and require that you keep this business structure.
Here’s what the IRS says about choosing between an s-corporation (S corp) and c corporation :
“Generally, if your business is not a personal service corporation, we recommend that it be organized as an s corporation because of the additional tax benefits available to the shareholders in an s corporation. If you have decided that your business is a personal service corporation, then you should be organized as a regular c corporation.”
This recommendation is available on Form 2553. On this form, you need to check one box indicating if you are planning on using an S Corp or a C Corp.
C Corps and S Corps are separate legal entities, which means you will need to file two different state forms for your business to be legally formed.
How to Decide Between S-Corporation vs. C-Corporation
So which should you choose? For most small business owners, an S Corp will save money on tax returns. You don’t have to pay separate taxes on your income, and because you cannot take a distribution from an s corporation, there is no threat of double taxation like there can be with a C Corp.
In contrast, C Corps have more flexibility when it comes to raising money from investors. During the fundraising process, you are not liable for any corporate debts or actions that take place after you transfer ownership of the company.
Advantages of an S-Corp
1. Single Tax Return for the Company and Shareholders
In an s-corporation, profits are shared between the shareholders and the company. As a shareholder, you report your share of gains on Schedule E (Form 1040). On Schedule E, a section titled “Ordinary Business Income or Loss,” separates the company’s income from your salary.
In other words, as the business owner of an S Corp, you will not have to pay “self-employment tax” on the part of your income (in contrast to a C Corp). Self-employment taxes are required if you draw any money from your business.
2. Multiple Shareholders Can Be Eligible for a Pass-Through Deduction
If you have multiple shareholders, then each shareholder can deduct their share of the company’s losses on Schedule E. In contrast, with a C Corp, losses are reported by individual shareholders using Form 4797. If you run into any problems during the tax season, talk to an accountant or tax professional.
3. Can Be Taxed as a Partnership or S Corporation
With an s-corporation (S corp), you have the option to tax your business as either a partnership or an s corporation. The default choice is “100% pass-through,” which means shareholders will report all profits on their individual returns (Schedule E). The only exception is if you own a personal service corporation (discussed in #8 below).
4. No Corporate Tax on Investment Income or Capital Gains
As mentioned earlier, because S-corporations are pass-through entities, the profit and losses of the corporation are reported on the personal income tax returns of shareholders (Schedule E). In contrast, C Corps do not have pass-through taxation. This means that all corporate profits or losses are consolidated into an IRS return and taxed at the corporate level.
5. Business Assets Can Be Transferred to Shareholders
If you decide to sell the business in its entirety, you can transfer all assets to each shareholder (or their estate). You would need to pay capital gains tax on any profits transferred from the corporation with a C Corp.
6. Can Be Used for Involuntary Conversions and Depletion Allowances
An involuntary conversion occurs when your property becomes unusable due to a casualty or disaster. Losses from involuntary conversions can be deducted against other income, but the loss must exceed 10% of your income in order for you to qualify for this deduction.
If your property was partially damaged in an incident, you might also be able to claim a “depletion allowance.” Depletion allowances are used for natural resources and mineral properties, which must be depleted before you can sell them.
7. Tax-Free Reorganizations
Entrepreneurs who own an S corp have the option to reorganize their company without incurring taxes. Specifically, if your business is a partnership (or limited liability company), then you may restructure your business in a way that does not transfer ownership of the property.
For example, you could change from a partnership to a limited liability company (LLC) without incurring taxes on any capital gains or losses. While C Corps do not have this option, it is important to know that a sale of the business to another party will generate tax liabilities.
In addition, you can also transfer a partnership’s assets to another partner. As mentioned in #5 above, this is not possible with C Corps. These options may be helpful if you leave the business for any reason (e.g., retirement, illness).
Advantages of a C-Corp
1. All Income Is Taxed at the Corporate Level
As mentioned before, corporate profits and losses are consolidated into an IRS tax return ( Form 1120 ). This is the case whether or not you draw any income from your business. However, if you decide to draw a salary, then this will be reported on Line 17 of Form 1040.
2. Can Have Stockholders who are NOT Eligible for a Pass-Through Deduction
If you want to grow your business or raise outside capital, then you have the option of selling stock in your company. C Corps have this advantage over S-corporations (S corps). In addition, C Corps can give out incentive stock options to employees. These are not possible with s-corporations.
3. Can be Used for a Holding Company
If you own multiple businesses or plan to start new ones in the future, then you can use a holding company as an umbrella organization over your other companies. This will allow different business entities to pool their resources, which will help with taxes and bookkeeping.
In contrast to an S corp, corporate profits or losses are not reported on the personal tax return of shareholders.
4. Corporate Stock Can Be Sold on Open Exchanges
C Corp stocks can be bought and sold publicly through open exchanges. This is one of the main reasons that C Corps are often used for large corporations. S Corp shares, on the other hand, cannot be sold on stock markets.
5. Tax Benefits and Breaks for Qualified Small Business Stock
If you own qualified small business stock (QSBS), then congratulations! This one class of stock will provide you with tax benefits and preferential treatment. Qualified small business stocks are those acquired through certain means (e.g., in exchange for rolling over a 401(k) into an IRA).
If you own QSBS, then any profits earned on that stock will be treated as capital gains tax instead of regular income. On top of that, qualified business income will also receive preferential tax treatment.
Disadvantages of an S-Corp
1. A Two-Tier Tax System
If your business is structured as an S Corporation, you will be taxed twice (on the individual and corporate levels) . Since this may provide additional tax liability to you, it’s important to understand how this two-tier system works:
The first time that your corporation pays taxes is when it files its own corporate taxes. After that, the corporation will pass on its profits or losses to you as a shareholder. In other words, the s-corp pays taxes similar to how a limited liability company or partnership does.
When you file your own income tax return (1040), your personal income tax rate is reduced by the amount your s-corp pays in corporate taxes. This occurs because you have already been taxed on those profits at the corporate level.
As mentioned before, making this change from a partnership or LLC to an S Corporation is not taxable. However, if you sell your company and make money off of it (either by selling your business or your stock), this will be taxed as a capital gain.
2. No Pass-Through Deduction
Unlike the C Corporation, an S Corporation’s profits are not tax-free at the individual level. This means you must pay taxes on these earnings like you would for any other source of income. Since an S Corporation does not issue W-2 forms to its shareholders, then all income and losses are reported on the owner’s personal tax returns.
In contrast, C corporations do issue W-2s to their employees. This is why S corps will generally pay lower wages (to avoid paying out higher taxes).
3. Cannot be Used for a Holding Company
If your business is structured as an S Corporation, then you cannot use it as an umbrella organization over other businesses. In other words, the s-corp does not have the ability to pool its resources with another entity (e.g., C Corp). This means that multiple entities cannot be centrally controlled.
Disadvantages of a C-Corp
1. Double Taxation
In a traditional C-Corp, the corporation must pay taxes on its profits (and then those earnings are passed down to the shareholders). Because of this two-tier tax system, C Corps will usually pay out high salaries or bonuses in order to avoid paying higher corporate taxes. This is why S corps often offer higher wages to their employees (in order to avoid paying out higher dividends).
2. Cannot be used as an Umbrella Organization
If your business is structured as a C Corporation, then it cannot work under another corporation (such as an S Corp or LLC ). This means that the c-corp must stand on its own—it will not be able to pool its resources (assets, income, etc.) with another business.
3. Cannot Be Restricted from Foreign Investors
As mentioned before, an S Corporation can be restricted from accepting foreign investors. While this may seem like a disadvantage at first glance, there is one main advantage: private shares.
Since C Corps are publicly tradable, they must accept any interested party who wants to buy a share. This means that your shares could be bought by anyone: foreigners, competitors, etc.
How to determine whether an S Corp or C Corp is right for you?
Now that we have gone over the advantages and disadvantages of S corporation vs. C corp, it is necessary to determine which business structures are right for your business. If you are a single-member LLC or partnership, then you can elect to be taxed as an s-corp (but you will not get some of the additional benefits offered by an LLC).
- If you are a traditional one or two-member business, then it may make more sense to convert your business into an S corp (if you want to attract foreign investors and offer better wages to your employees without paying higher corporate taxes).
- Alternatively, if privacy is of extreme importance to you, it may be best for you to form a c-corp (if you have more than 100 shareholders or multiple persons control your company).
- If you are a larger organization with many shareholders, then it may make sense to have separate s-corporations structured around each division of the business. This is because S Corps allows you to limit the number of new shares a corporation can issue to new shareholders (and they allow you to prevent new classes of stock from being issued). Thus, if a potential investor is interested in buying 5% of your company and cannot buy more units than that, you can simply start a new s-corp for that division.
Finally, remember that there is no one right answer when it comes to choosing the best business entity type. The choice between an LLC vs. a corporation will depend on your specific situation and goals for the future.
The Bottom Line: C Corp vs. S Corp Comparison
In general, there is no tangible difference between using an s corporation (S corp) and a c corporation (C corp) from a taxation perspective.
If you are looking at this step from an investment perspective, then C Corps will probably be easier to attract outside funding, while S Corps will save you money on taxes.