A lot of time it happens that when an individual wants to start a new business, or perhaps, make certain changes to his/her current business structure, one of the most common options the individual or an already established business owner would want to evaluate is whether to form a C Corporation (C-Corp) or an S Corporation (S-Corp).
This, however, may seem overwhelming to some individuals, especially if you are not aware of their difference. Businesses can choose to structure their companies as C Corporation or S Corporation, which depends on their ideal business tax structure.
C-Corps are taxed both at the corporate level and on the owners’ personal income tax returns if corporate income is distributed to the corporation’s shareholders as dividends. S-Corps, on the other hand, are considered pass-through entities, where the business’ profits and losses are reported on the business owner’s income.
We shall look more into detail about C-Corps and S-Corps and also understand their key differences that will help you decide which one is the best option for you to get started with.
A-C Corporation (or C-Corp) is the standard and most common type of corporation. Here, the shareholders who have purchased stock in a company own the corporation and these shareholders enjoy limited liability protection. In other words, shareholders of corporations are not personally liable for the business’ debts or obligations.
This is a major selling point of a corporation. Although the shareholders of a C Corporation own the business, they cannot make most of the decisions. Only the management and policy issues are left to the company’s board of directors, who are elected by the shareholders.
Also, the normal day-to-day work of running the business is on the officers of the C Corporation, such as the CEO, COO, and CTO, respectively.
So, in order to set up a business as a C Corporation, it is necessary to file articles of incorporation with the respective state government. After your business becomes operational, you have certain compliance to adhere to and documentation obligations as a corporation. These include issuing stock, paying fees and holding shareholder and director meetings.
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S Corporation is also called a subchapter S corporation. The name is after the section of the tax code that regulates these types of businesses. The corporation owners elect to structure the business as an S Corporation.
Similarly, C-Corps, S-Corps also come with limited liability for shareholders. However, the main difference is that the owners of an S-Corp can take advantage of pass-through taxation.
This means that the profits and losses of the corporation are reported on the owners’ personal tax returns. There is no corporate income tax on S-corps. An S Corporation has similar documentation and compliance obligations as that of a C-Corp.
S-Corp needs to file its articles of incorporation and is also required to issue stock, hold shareholder and director meetings, etc.
S-Corp is different from C-Corp (which is also a regular corporation) only in that it elects to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code of the IRS. Congress created Subchapter S in the tax code in 1958 in order to promote small businesses and entrepreneurs
S-Corps merges and combines the advantages of partnerships (single taxation) with the limited liability offered by corporations. On the other hand, the C-Corps target and allow more flexibility in the number and type of shareholders, as well as different classes of stock.
The C Corporation is the standard corporation in contrast the S Corporation elects a special tax status with the IRS. It gets its name because it is defined in Subchapter S of the Internal Revenue Code of the IRS. In order to elect S corporation status when forming a corporation, Form 2553 must be filed with the IRS and all S corporation guidelines must be met.
However, both C Corporations and S Corporations also share many qualities, such as.
(a) Limited liability protection:
Both C-Corps and S-Corps offer limited liability protection, so shareholders (who are owners) are not personally responsible for any business debts and/or liabilities.
(b) Separate entities:
Both C-Corps and S-Corps are two separate legal entities that are created by a state filing.
(c) Filing documents:
Formation documents are required to be filed with the state. These documents, are known as the Articles of Incorporation or Certificate of Incorporation, are the same for both C and S corporations.
Both have shareholders, directors, and officers. Shareholders are popularly known as the owner of the company and elect the board of directors, who in turn oversee, direct corporation affairs and make decisions, but are not responsible for day-to-day operations. In order to manage daily business affairs and issues, the directors elect the officers to manage and maintain it.
(e) Corporate formalities:
Both are quite essential to follow the same internal and external corporate formalities and obligations, such as adopting by-laws, issuing stock, holding shareholder and director meetings, filing annual reports and paying annual fees.
If you choose to structure your business entity as a corporation, you will be faced with an important decision, which is, whether to set up your business as a C-Corp or an S-Corp. The choice you make will also have major implications as to how much you will pay in taxes, your ability to raise money and the ease with which you can expand your business.
When you are a small business owner, not a lawyer or accountant, it can be hard to understand the differences between C Corporations and S Corporations. Luckily, the differences come down to three main areas: formation, taxes, and ownership. In most other respects, C-Corps and S-Corps are, otherwise, similar.
Despite their many similarities, C-Corps and S-Corps have various distinct differences as well. These include:
Taxation is often considered the most crucial and significant difference for small business owners when evaluating S corporations and C-corporations.
(b) C Corporations:
C corps are separately taxable entities. They also cope up with the possibility of double taxation if corporate income is distributed to business owners as dividends, which are considered personal income. First of all, Tax on corporate income is paid first at the corporate level and again at the individual level on dividends.
(c) S Corporations:
S-Corps are pass-through tax entities and they file an informational federal return (Form the 1120S), but no income tax is paid at the corporate level. The profits/losses of the business are instead passed through the business and reported on the owners’ personal tax returns.
(d) Personal Income Taxes:
Along with both types of corporations, personal income tax is due both on any salary was drawn from the corporation and from any dividends received from the corporation.
(e) Corporate Ownership:
C-Corps don’t have no restrictions and limitations on ownership, but S-Corps do. S-Corps are restricted to no more than 100 shareholders and shareholders must be US citizens or residents. S-Corps cannot be owned by C-Corps, other S corporations, LLCs, partnerships, and many trusts. Also, S-Corps can have only one class of stock (disregarding voting rights), while C-Corps can have multiple classes.
C corporations, offer a little more flexibility when starting a business if you plan to grow, expand the ownership or sell your corporation.
In order to be an S-Corporation, you must file Form 2553 with the IRS. The IRS instructions, which may be a little challenging to follow, require that an election is considered effective in the current tax year only if the Form 2553 is completed and filed:
(i) Any time before the 16th day of the 3rd month (for calendar year taxpayers, this means it needs to happen by March 15th)
(ii) Any time during the preceding tax year (however, an election made no later than 2 months and 15 days after the beginning of a tax year that is less than two and a half months long is treated as timely for that year).
Generally, an election made after the 15th day of the third month, but before the end of the tax year is effective for the next tax year (unless you can show a failure to file on time was due to reasonable cause). Some states also want you to file a state-level S corporation election once you incorporate your business.
Now that you know the major differences between C-Corps and S-Corps, the question arises how can you decide between the two business entities? Many small business owners usually choose an S-Corp status that helps save money on taxes. However, if you are planning to raise investor money in the future or have plans to grow into a large company, then C-Corp might be a better option for you.
A lot of the benefits and disadvantages of both entities lie in their differences. Let’s take another look at some of the pros and cons of C Corporations and C Corporations.
C Corporations: Pros and Cons
(a) Easier to Form:
C-Corps, being the default type of corporation, does not require any additional paperwork to be filled.
(b) Fringe Benefits:
C-Corps can deduct the cost of fringe benefits provided to employees, like disability and health insurance. Shareholders of a C corporation do not have to pay taxes on their fringe benefits, as long as 70 percent of the corporation receives the same fringe benefits.
(c) Charitable Donations:
C corporations are the only type of business entities that can deduct 100 percent of charitable contributions. The donations cannot exceed 10 percent of the business’ total income.
(d) Easier to Raise Money:
It is easier to raise money because C-Corps can issue multiple classes of stock to an unlimited number of shareholders. Plus, investors face no liability for the corporation’s mistakes, making it much easier to put money toward the business. Another advantage to note is that other businesses can own C-Corps outright, which might be a better fit for companies looking to be acquired.
(e) No Shareholder Limit:
C-Corps can have as many shareholders as needed and can also have foreign (non-resident alien) shareholders, making it an ideal business entity for any company that intends to deal overseas.
(a) Double Taxation:
C-Corps might pay more in taxes due to double taxation. The company’s revenue will be taxed at the corporate level and again at the personal level if it is distributed as shareholder dividends.
(b) No Personal Write-offs:
Owners cannot write-off the losses of the business in their personal income statements, off-setting income from other sources. Bigger companies usually benefit from having unlimited growth potential under a C-Corp, but typically pay a little more in taxes, reducing their net income. They also spend a little more effort complying with more regulations.
However, this could change with the new tax laws as C Corporation owners will end up paying less in taxes.
(a) Pass-through Taxation:
The taxation structure of S-Corps is its major benefit. They do not have to pay taxes on the business’ income twice. Thus, avoiding double taxation is a huge benefit for smaller businesses.
(b) Deduction of Business Income:
Current law allows owners of most S-Corps and other pass-through entities to deduct 20 percent of their business income on their personal tax return, which can significantly reduce your tax burden.
(c) Tax Filing Requirements:
Owners of S-Corps can write off their business’ losses on their individual tax returns. This is a benefit for newer corporations that are operating at a loss for the first few years. Being an owner, you can write off the losses of the business on your personal income statements, offsetting your income from other sources.
(a) Not Easy to Form:
You have to file Form 2553 with the IRS and possibly additional state paperwork to elect S-Corp status. Also, you must ensure that you stay within any restrictions such as the 100 shareholders limit, in order to maintain S-Corps status and avoid penalties in the future.
(b) Limited Ownership:
Unlike C-Corps, S-Corps have some cap on the number of shareholders they can take on, which is up to 100 shareholders. Also, shareholders have to be legal residents of the United States. This poses a problem for expanding businesses, or businesses looking to conduct business affairs on an international scale.
(c) Limited Stock Flexibility
S-Corps prevent you from issuing preferred stock and different classes of stock, which can make it harder to raise money from investors and incentivize early owners.
(d) Tax Qualifications:
S-Corps tend to have more IRS scrutiny. So, if you make a mistake, for example, going over 100 shares or missing a filing deadline, the IRS can terminate your S-Corps status and you will be taxed as a C-Corp.
Before you finally settle on a C-Corp or S-Corp business structure, remember to consider other types of business entities. LLCs, in particular, is a very small business-friendly type of ownership structure. They offer limited liability and less paperwork and regulatory requirements than corporations.
Now that you are aware of the major differences between C-Corp and S-Corp, along with their advantages and disadvantages, you are well-equipped to make a smart choice for your business. S-Corps allows many small businesses to save money on taxes, but C-Corps give you more options to expand and raise money.
Keep in mind that the way you structure your business is going to be a big decision and will have much greater implications on the future of your business. So, if you still feel unsure about choosing your business entity, or correctly structuring your company, then consider consulting a small business lawyer or a professional accountant to guide you with suggestions.