If you have your sights set on incorporating your business, you may be wondering if a C Corporation or S Corporation is the better option. While both are popular choices, nuances exist that may make one or the other more advantageous for your situation. The business structure you choose will affect your company in many ways, including the legal and financial aspects. That’s why it’s critical to do some research and ask for guidance from an attorney and accountant or tax professional when deciding.
In this article, I’ll compare the C Corp vs. the S Corp. This review will help you prepare for those crucial conversations with your lawyer and tax advisor.
C Corporation and S Corporation get their names from the sections of the Internal Revenue Code that establish the rules for how they are taxed.
When a business files its incorporation paperwork, it is by default considered a C Corporation. A corporation must make a special filing to request S Corporation status.
Note that when I mention S Corporations in this article, I am referring to C Corporations that have elected to be treated as S Corporations. Eligible LLCs may also choose to be treated as S Corporations, and some of the rules they must follow differ from those that apply to C Corps operating as S Corps.
C Corp and S Corp Similarities
C Corps and S Corps have several things in common.
1. Limited Liability for Owners
C Corporations and S Corporations are separate legal entities from their owners (a.k.a. shareholders). As such, they provide limited liability protection to those shareholders. So, unless the owners have personally been negligent or reckless, their personal assets are protected from debts and legal claims against the corporation.
2. Formation and Other Filings
Creating a C Corporation or S Corporation requires business registration at the state level (usually with the Secretary of State office) and filings at the federal level as well. Depending on where the corporation will operate, it may also have county and local municipal filings to fulfill, too.
The state document to establish the entity is typically called Articles of Incorporation or Certificate of Incorporation. States also require that corporations designate a registered agent and obtain any necessary business licenses and permits related to their location, industry, and professional activities. States may require other filings, too. In addition, corporations must adopt bylaws that document how the affairs of the business will be conducted. Corporations do not have to submit bylaws to the Secretary of State. However, they must keep them in a safe place at their business so that they are available to shareholders and other stakeholders.
At the federal level, the business must obtain an EIN (Employer Identification Number). If it wants to be treated as an S Corporation instead of a C Corp for federal tax purposes, it must complete a special IRS form (more on that later!).
3. Management Structure
C Corporations and S Corporations are owned by shareholders who elect a board of directors to oversee and direct the business’s decision-making. The board elects officers (e.g., President, Vice President, Treasurer, Secretary) who have responsibility for carrying out the board’s policies and managing certain operational aspects of the company. Day-to-day tasks and responsibilities are typically handled by the corporation’s employees (managers and other staff).
The roles and responsibilities of the board and rules for how a corporation is managed and operated should be laid out in the company bylaws.
4. Corporate Compliance Formalities
States require C Corps and S Corps to keep up with various ongoing compliance responsibilities. The exact rules vary from state to state. Some of the typical requirements include:
C Corp and S Corp Differences
1. Additional Formation Paperwork
A corporation that wants S Corporation status must file Form 2553 (Election by a Small Business Corporation) with the IRS. States might also have additional filing requirements for a business to be treated as an S Corp for state income tax purposes.
2. Tax Treatment
C Corporations are separate taxable entities. They must file a federal corporate income tax return (Form 1120) and pay the federal corporate income tax rate. Corporate income that is distributed to owners as dividends is double-taxed. In other words, profits are taxed at the corporate rate and then at the individual rate when distributed to shareholders and reported on their personal income tax returns.
S Corps, on the other hand, are “pass-through entities.” They must file an information return with the IRS (Form 1120S) but do not pay corporate taxes. Instead, profits and losses flow through to the S Corp’s shareholders, who report and pay tax according to their individual income tax rates.
C Corps and S Corps must put shareholders hired as employees onto the company payroll and withhold applicable payroll taxes from their wages and salaries. Half of the 12.4% Social Security tax and half of the 2.9% Medicare tax (known collectively as “FICA” tax) is withheld from employees’ pay and the corporation pays the other half. Dividend distributions to shareholders are not subject to Social Security and Medicare taxes.
Corporations have virtually no restrictions on who can own them.
Conversely, the IRS restricts who can be a shareholder in an S Corporation. S Corps may not be owned by C Corporations, other S Corps (in most situations), LLCs, partnerships, and most trusts.
Moreover, a C Corp can have an unlimited number of shareholders while an S Corp may not have more than 100.
4. Stock Flexibility
C Corporations may issue multiple classes of stock to their shareholders (e.g., common stock and preferred stock). So, some shareholders can receive preferential treatment, such as receiving a fixed dividend distributed before common stock dividends are issued or special voting rights.
S-corporations are limited to issuing common stock. That means there’s only one class of shareholders, with all shareholders having equal rights to distributions and voting.
Pros and Cons
Here’s an overview of the possible benefits and drawbacks of operating as a C Corp or S Corp.
C Corporation Pros
- With no restrictions on the number of shareholders and eligibility requirements for who can be a shareholder, C Corps have more options when seeking investors, including other corporations and foreign individuals and entities.
- It may be easier to sell a C Corp than an S Corp due to no restrictions on ownership.
- C Corporations have greater deduction possibilities. They’re the only entity type that can deduct 100% of their charitable contributions (not to exceed 10% of total business income). Also, they can deduct certain fringe benefit expenses (e.g., health insurance, tuition reimbursement, bonuses).
- Because C Corps can issue preferred stock, they may attract more investors.
- The current federal corporate tax rate of 21% is lower than the rate in several federal individual tax brackets.* So, forming a C Corp may save some shareholders money if they fall in the higher personal tax tiers.
C Corporation Cons
- Double taxation may result in a heavy tax burden overall when some business profits get taxed at the corporate level and then again on shareholders’ personal income tax returns.
- Owners may not write off the business’s losses on their individual tax returns. That might hurt their personal tax situation if they would benefit from using their portion of the corporation’s losses to offset income from other sources.
S Corporation Pros
- Pass-through taxation may lower shareholders’ Social Security and Medicare tax burden. S Corp shareholders only pay Social Security and Medicare taxes on their wages and salaries from the business — not on the dividend distributions they receive.
- The business’s losses flow through to the individual level, thus lowering each business owner’s income subject to income tax.
- It provides an opportunity for shareholders to lower their income tax burden when individual tax rates are lower than the corporate tax rates.
- Presently, because of the Tax Cuts and Jobs Act of 2017, eligible S Corp shareholders can deduct up to 20% of net “qualified business income,” which helps reduce the business owners’ personal tax liability.
S Corporation Cons
- Potential to raise funds to start and grow the business may be limited because of the cap on the number of allowed shareholders.
- An S Corporation may find it more difficult to get equity financing because of the restrictions on shareholder eligibility.
- It may be harder to find investors because S Corps cannot issue different classes of stock. Some investors may not be willing to invest in an S Corp because the structure does not allow preferential treatment to key shareholders.
- Not all states have tax codes that treat S Corps differently than C Corps.
- S Corps may face a heightened level of IRS scrutiny, especially if shareholders’ salaries seem too low for the work they are performing.
We’re Here to Help
As you can see, there’s a lot to consider when deciding between running a business as a C Corporation or S Corporation. After you’ve done your due diligence and have thoroughly discussed the advantages and disadvantages of your options with an attorney and tax expert, CorpNet is here to help! We handle preparing and filing Articles of Incorporation and a full range of other filings and registrations for business owners in all 50 states.
Don’t leave your business startup paperwork to chance! Get peace of mind that our knowledgeable filing experts have it under control. Contact us today! We’re excited to help you start and grow your business successfully!
*May change with future tax code reforms