S Corp Vs. C Corp: What’s the Difference?
Which should you choose?
- January 3, 2020
- Starting Your Business
- 10 min read
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When you start a business, one of the first decisions you’ll face is how to structure your company. You have several options to choose from, such as being a sole proprietor, forming an LLC or partnership, or incorporating your business. If you are to choose the latter, you’ll come to face another decision: Which type of corporation should you incorporate as, a C corporation or S corporation?
A C corporation, or C corp, and an S corporation, or S corp, are both corporations. Therefore, they have many similarities on a fundamental level. Where they differ, however, is crucial to your business, as well as to you as a business owner. Read on to find out the difference between an S corp and C corp is to determine which you should choose.
The most basic similarity C corporations and S corporations share is that they are corporations — not sole proprietorships, LLCs or partnerships. This is the fundamental characteristic of both C corps and S corps. By default, when you incorporate your business, the IRS will consider it a C corporation. Becoming an S corporation requires a few more steps to take detailed below.
These business structures are named after the parts of the IRS Code that they are taxed under. For example, C corporations are taxed under Subchapter C and S corporations are taxed under Subchapter S. In both corporate structures, owners are called shareholders and they are issued shares of stock in the company. Below are some additional qualities shared by both C corporations and S corporations:
- Limited liability protection: In a trait shared by LLCs, both types of corporations provide limited liability protection for owners. Meaning, owners are typically not personally responsible for business debts and liabilities.
- Distinct legal entities: Both C corps and S corps are classified as separate legal entities created by a state filing.
- Filing documents: Documents pertaining to the formation of the company must be filed with the state. In general, these documents are called Articles of Incorporation, sometimes Certificate of Incorporation, which are the same whether you elect to be taxed as an S corporation or remain a C corporation.
- Business structure: A defining characteristic of both S corps and C corps is that they have shareholders, directors and officers. The shareholders elect the board of directors, which oversees and directs corporation decisions, but is generally not responsible for day-to-day operations. Instead, the board of directors elects officers to manage daily activities. An important point to take away is that shareholders are the owners of the corporation, yet it’s the corporation that owns the business.
- Corporate requirements: All corporations are required to follow corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder and director meetings, designating and maintaining a registered agent and registered office, filing annual reports and paying fees.
On a fundamental level, therefore, S corporations and C corporations are quite similar. However, their differences give rise to major considerations you’ll need to make when choosing a structure. Read on to find out the key differences between these two types of businesses to determine which might be right for you business.
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When small business owners are deciding between making their company an S corporation versus a C corporation, the principal areas to look at are taxation and ownership. These areas hold the key differences between these two business structures.
|C Corporation||S Corporation|
|How to Form||C corp is the default type of corporation at formation||S corp is formed by filing IRS Form 2553, in which business elects for new status|
|How They’re Taxed||1) Corporate tax
2) Personal income tax on dividends
|1) Personal income tax on profits, called pass-through taxation|
|How Shares Work||1) Unlimited shareholders
2) Multiple classes of stock, such as preferred stock
|1) 100 or fewer shareholders
2) Only one class of stock
|Who Can Be Shareholders||1) Individuals and businesses can be shareholders
2) U.S.-based and foreign shareholders are permitted
|1) Shareholders must be individuals and not businesses
2) Shareholders must be U.S. citizens or residents
|Raising Capital||Better for raising venture capital because of no restrictions on shareholders||Harder to raise venture capital because of restrictions on who can be a shareholder|
Taxes are handled differently for different business structures. Here’s an overview of taxation for C corporations and S corporations:
- S corporations: S corporations are considered pass-through taxation entities by the IRS. You file Form 1120S, U.S. Income Tax Return for an S corporation with the IRS, which is informational and no income tax is paid at the corporate level. The profits and losses of the company instead pass through the business and are reported on the owners’ personal tax returns.
- C corporations: In terms of taxation, C corporations are separately taxable entities. They file a corporate income tax return Form 1120, U.S. Corporation Income Tax Return, thus paying taxes on the corporate level. In addition, C corporations typically deal with double taxation. This occurs when corporate income is distributed to business owners as dividends, which is taxed as personal income. Therefore, the income of C corporations is taxed at the corporate level and a second time at the individual level on dividends.
Here’s an overview of how ownership and shares are handled for each type of corporation:
- Shareholder restrictions: S corporations are restricted to a maximum of 100 shareholders. Also, with S corporations, shareholders must be U.S. citizens or residents. C corporations, on the other hand, have no restrictions on ownership.
- Ownership: Ownership of S corporations is limited to individuals. This means that S corporations cannot be owned by C corporations, LLCs, partnerships or many trusts. C corporations do not have these restrictions.
- Stock: S corporations can have only one class of stock, meaning they cannot issue preferred stock, for instance. C corporations can have multiple classes.
Fringe benefits are non-wage compensation that companies provide for employees. Basic examples of this are health, life, and disability insurance. With a C corporation, the cost of providing these fringe benefits can be deducted by the corporation. They’re also not taxable to the shareholder if the benefit is provided to at least 70 percent of employees. With an S corporation, on the other hand, you can’t deduct the cost of benefits. Instead, they become taxable to shareholders who own more than 2 percent of the corporation’s stock.
There is no obvious answer as to whether an S corp is better than a C corp or vice versa. The decision is principally dependent on your business, circumstances and hopes of where your company will go in the future. Here are some of the typical pros and cons of an S corp so you can weigh if it’s right for you.
Here are some pros of forming an S Corporation:
- Single taxation: A C corp pays corporate income tax and shareholders are taxed on dividends, sometimes referred to as double taxation. With an S corp, the company is not subject to corporate income tax and shareholders are only taxed at the personal level when distributions are paid out, which could save you money on taxes.
- Pass-through taxes: It might seem weird to mix personal and business taxes with your company, but there are some advantages. For example, you can use the losses of an S corp to offset income on your personal taxes and save money since an S corp is a pass-through tax entity.
- Other tax-friendly features: With an S corp, shareholders can be employees of the company and therefore draw salaries. This can help you reduce your self-employment tax liability plus generate business expenses that can be tax deductible.
Here are some cons of forming an S Corporation:
- Limited number of shareholders: An S corp cannot have more than 100 shareholders. This restriction is crucial because it means an S corporation can’t go public, thus limiting its capability to raise capital from new investors.
- Other shareholder restrictions: With only a few exceptions, shareholders of an S corporation must be individuals and American citizens or residents. This restriction again limits an S corporation’s options for raising capital since private equity and venture capital firms cannot be shareholders.
- Transfer restrictions: A common restriction in S corporations is that they will restrict their shareholders’ ability to sell or transfer their shares. This restriction inhibits the ability of an ineligible shareholder to buy in, which would cause the IRS to terminate the company’s S corp status. As a result, it can be harder for the shareholders of an S corp to exit the corporation.
Incorporating as a C corp tends to make sense when you’re aiming to make a big company. While all entrepreneurs want their businesses to succeed, size is not equivalent to success. However, there are circumstances and conditions which can make a C corp a better option over other business structures like an S corp.
Here are some pros of forming a Corporation:
- No limit on number of shareholders: There is no limit to the number of shareholders a C corporation can have.
- No restrictions on ownership: Shareholders can be anyone, including business entities and non-U.S. citizens.
- Raising capital options: Due to the fact that Subchapter C of the tax code does not impose the same restrictions on ownership as Subchapter S — namely ownership of shares by a business entity — it is usually easier for a C corp to obtain equity financing.
Here are some cons of forming a C corporation:
- Double taxation: The principal disadvantage of the C corporation is that it pays tax on its earnings — both federal and state corporate income tax — and the shareholders pay tax on dividends, meaning the corporation’s earnings are taxed twice.
- Government oversight and regulations: Government oversight of C corporations is generally greater than for S corporations. The reason is due to the complexity of accounting and taxes for C corporations as well as the degree of protection it affords shareholders.
- Loss deduction: Owners of C corporations cannot claim business losses on their personal tax return and thus offset income taxes. The corporation reports corporate losses in its corporate income tax return.
People commonly believe that you form a C corp or an S corp. In reality, the key point is that you form a corporation, which is the defining characteristic that sets them apart from sole proprietorship, partnership or an LLC. The crucial difference between an S corp and a C corp is in taxation, not formation.
To form a corporation, you file a document known as Articles of Incorporation with the state and pay filing fees. This is the principal document for incorporation, but there are many other important documents needed to create a corporation.
When both forming a C corp or S corp, once the incorporation process is done, you’ll need to complete some further steps. Typically, these will include holding a meeting of directors and shareholders, issuing shares of stock to owners and establishing bylaws. By default, the business you incorporated will be taxed under IRS Subchapter C unless you qualify and elect to be taxed under Subchapter S.
To become an S corp, the critical step is filing documents with the IRS. In this case, once you’ve incorporated, you need to file Form 2553, Election by a Small Business Corporation, with the IRS. Your company will need to meet certain tests by the IRS to qualify for becoming an S corp. Other requirements include all shareholders signing a consent statement, the signature of an officer and the name and address of the corporation. Bear in mind that some states might require you to file a state-level S corp election document as well.
When you first incorporated your business, you had to choose whether your corporation would be taxed as a C corp or an S corp. However, it is not uncommon for business owners to change their mind about corporate structure. Many factors can play into this, such as a change in goals or the direction of the business or wanting to get investors like other companies to buy into your corporation, which is not allowed for S corporations.
Since such situations are very normal, you are allowed by the IRS to convert one corporation type into another. Essentially, the main requirement the IRS stipulates is filing Form 2553, in which you and all shareholders sign off on electing to be recognized as an S corporation. Of course, your company will need to comply with S corporation requirements in order to qualify for conversion.
What about converting from an S corporation to a C corporation? In this case, the IRS actually doesn’t offer a standard form for changing your tax status from an S corp to a C corp. Rather, the IRS just requires a written statement to be filed with the appropriate IRS service center, along with a consent signed by a majority of your corporation’s shareholders.
Deciding on the business entity type for your company has major implications for your business now and in the future. On the plus side, you have the ability to convert your corporation’s structure and tax status down the line without too much trouble, though you’ll have to put in some effort as the business owner. The biggest area of impact arising from being an S corp versus C corp is in taxes and ownership, so this is where you should focus your decision making. Weighing the advantages and disadvantages of your options before choosing can help you reach a decision that fits best for your business needs and goal.
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