C Corporation vs. S Corporation: What are the key differences?
In the very first stage of business development, the question inevitably arises — how should the business be legally established?
A business structure does not only define a business’s legal standing but at times, helps to define the direction which can impact future success.
In this article, we’ll take a closer look at how to register a business from the standpoint of a corporation. We will go through its two key types: C Corporation and S Corporation. Proceed to US Legal Forms to access the do-it-yourself with the incorporation package.
Looking ahead, one of the biggest differences between C and S corporations is their tax liabilities. C corporations pay taxes on their income, i.e., the income the owners and employees are responsible for. In contrast, the S corporation doesn’t pay tax. Instead, it reports the company revenue as personal income.
So What Stands Behind C-Corp and S-Corp?
Considering what’s right for your business in terms of taxing and a business owner’s liability, there are a variety of options in choosing a business structure. Starting with the most common — Limited Liability Company (LLC) and ending with the more complex structure — a Corporation.
LLCs are easier to set up and are operated by the SMB owner. However, they are harder to invest in from the outside. While a corporation is a type of business entity with specific corporate formalities to follow and owners known as shareholders. In fact, corporations register themselves annually, meet licensing requirements, hold board meetings, keep records of all actions and decisions that took place during the board meetings, maintain corporate records, accounting ledgers, and shareholder records, and issue stocks as per their laws and articles of incorporation.
Depending on Internal Revenue Code tax classifications, there are so-called “C-corp” and “S-corp” designations. These names come from the subchapters of the Internal Revenue Code — ‘C’ and ‘S’, respectively.
What Makes a C Corp Stand Out
A C-corp is the most common corporate tax status available for both corporations and limited liability companies (LLCs). Corporations are taxed as C-corps by default, but some can elect S-corp taxation instead. LLCs are typically taxed as sole proprietorships or partnerships, but they can also choose to be taxed as C-corps or S-corps.
C-corps gain popularity as there’s no restriction on who can own shares while having a problem with “double taxation” as it first pays a corporate income tax with a federal return (Form 1120). The shareholders then pay taxes on personal income at the individual level. This way, the taxes levied on dividends at both the corporate and individual levels negate the possibility of offsetting other income on personal income statements.
Some good C-corp examples would be huge businesses that have grown from scratch, including McDonald’s, Starbucks, Apple, and many more.
Defining an S Corp
S-corps are subject to double taxation and have a so-called “pass-through” tax structure. S-corps can maintain up to 100 shareholders. The taxing is handled differently as the income from dividends is only taxed at the individual level under the applied marginal income tax ranging from 10% to 37%. The shareholders under specific criteria can offset corporate losses with income from other sources on their personal income statements.
An example of an S-corp is when owner A holds 51% of the stock in a corporation, while at the same time, owner B holds 49%. Let’s say the company’s net profits totaled $20 million. When filing their personal tax returns, owner A reports $10.2 million in income, and owner B reports $9.8 million. The corporation is free not to distribute the business’ proceeds and can keep the money inside the business. The shareholders will still be taxed on their portion of the profits.
Top 5 S-Corp vs C-Corp Tax Advantages
Both C-corps and S-corps feature different advantages. A proper evaluation can guide a business in the right direction and help owners choose what works best for them — forming a corporation or electing corporate status.
| C Corporation Advantages | S Corporation Advantages |
|---|---|
| No limitation on the number of the allowed shareholders: There is no limit on the number of shareholders a C corporation can have.
No restrictions on ownership: Anyone can own shares, there’s no restriction on shareholders’ countries of origin and corporate statuses. No restrictions on classes: A C-corp can issue more than one class of stock, including those with dividends and distributions. Lower maximum tax rate: The 2017 tax reform act lowered the corporate tax rate to 21% and reduced the alternative minimum tax. Even taking into account one’s personal income, the tax rates are slightly lower. More options for raising capital: C-corps can raise equity financing easier from outside sources |
Pass-through taxation: S-corps don’t pay corporate-level income taxes. So a shareholder’s income is only taxed at the individual level.20% qualified business income deduction: The Tax Cuts and Jobs Act of 2017 gave eligible S-corp shareholders a deduction of up to 20% of net “qualified business income.”
Pass-through of losses: Corporate losses are passed through to owners in some cases. They can then can use these losses to offset their income. Independence from shareholders: S-corps can still operate even if key shareholders depart. Lower self-employment tax: S-corps can lead to a lower self-employment tax for LLC owners who elect the S-corp tax structure. |
The C-Corp and S-Corp Disadvantages You Need to Know
There is no one-size-fits-all answer when choosing between an S corporation or a C corporation. However, when making a decision, it’s important to be aware of the disadvantages they both possess.
| C Corporation Disadvantages | S Corporation Disadvantages |
|---|---|
| Double taxation: A C corporation pays tax on its income and the shareholders pay tax on dividends, making the corporation’s earnings vulnerable to double taxation. | Limited number of shareholders: A S corporation can’t go public and raise capital from new investors if there are already 100 stakeholders. |
| No personal write-offs: The C corporation’s shareholders can’t write off their business losses on personal income statements. | Corporations have a more rigid structure and are more expensive: It takes more time and paperwork to maintain a C-corp than other business structures. |
| Preferred stock not allowed: To have an S-corp status, a company can’t have different classes of stock. An S-corp cannot offer preferences to distributions or other privileges that some investors may want. | Transfer restrictions: Most S-corps restrict their shareholders’ ability to manage their shares and make sure they don’t end up with an ineligible shareholder which will terminate its S-corp status. This makes it harder for an S-corp’s shareholders to exit the corporation. |
| Other shareholder restrictions: Shareholders must be individuals and US citizens or residents. This also makes it harder for an S-corp to obtain equity financing as venture capital and private equity funds are ineligible shareholders. |
C Corporation vs. S Corporation: Top 5 Similarities
When you first incorporate your business, choosing how your cooperation will be taxed turns out to be a tough task. Apart from being so different, C corps and S corps have some common qualities as well.
# 1. Limited liability protection
Both S Corps and C Corps benefit from limited liability protection and are not responsible for a corporation’s business debts or financial obligations. If anything happens to your business, you wouldn’t have to personally pay the expensive financial responsibilities or other debts the company has accumulated.
# 2. Separate legal entities
Both C Corporations and S Corporations can use separate legal entities, meaning that the company operates as a separate entity from its original company with separate liability from its ownership. Separate entities have a corporate shield from liability.
# 3. Filing documents
When you are filing your articles of incorporation with your state, the documents will be the same regardless of if you’re filing as a C Corp or S Corporation. While filing for an S Corp requires more documentation, the articles of incorporation are the same.
# 4. Structure,
Both types of corporations allow for their shareholders and ownership setup. S Corps and C Corps alike are incorporated similarly and are issuing stock and adopting by-laws. Both S Corps and C Corps file annual reports and have boards of directors and officers.
# 5. Corporate formalities
Although shareholders own the company, both have similar corporate structures. For example, a company is managed by the CEO and separate teams, while the board of directors handles policy and management concerns.
S corporation vs. C corporation: The key differences
While C-corps and S-corps have lots of qualities in common, such as limited liability for directors, they also have differences related to their tax structures.
# 1. Taxation
When evaluating S corporations vs. C corporations, your decision may depend on the way the corporation will be treated for federal income tax purposes.
C corporations: C corps are separately taxable entities that file corporate tax returns (Form 1120) and pay taxes at the corporate level. They also face the possibility of double taxation if corporate income is distributed to business owners as dividends which are taxable income as well. Corporate income tax is paid twice: at the corporate level and at the individual level on dividends.
S corporations: S corps are pass-through taxation entities and file a federal informational return (Form 1120S) with no income tax at the corporate level. The profits or losses of the corporation are “passed-through” and reported on the owners’ personal tax returns. Instead, the owners pay any tax that is owed at the individual level.
# 2. Personal income taxes
With C corporations and S corporations, personal income tax is formed by any salary drawn from the corporation and the dividends received from the corporation.
# 3. Corporate ownership
State corporation laws make no distinction between S corporations and C corporations, but the Internal Revenue Code does place several restrictions on who can be shareholders in order for a corporation to qualify as an S corp.
# 4. Shareholder restrictions
S corps are limited to the maximum number of 100 shareholders, and they must be US residents, while C corporations have no restrictions on ownership.
# 5. Ownership
S corporations cannot be owned by C corporations, other S corporations (with some exceptions), LLCs, partnerships, or many trusts.
# 6. Stock
S corporations can only have one class of stock, while C corporations can have multiple classes.
Where to Start When Forming Your Own Business
Starting a business is a big undertaking and covering all your bases is critical. However, there are specific things you will need to prepare for when establishing a corporation.
What’s needed to become a C Corp
Start by filing Articles of Incorporation or, less often, a Certificate of Incorporation with the state, and paying the filing fees.
Before filing documents, you have to choose a name for your corporation and state your corporation’s registered agent. This information will later be included in the Articles of Incorporation.
After the incorporation process is complete, you will need to adopt bylaws, hold an initial meeting of directors and shareholders, and issue shares of stock to owners. Your corporation will be taxed under IRS Subchapter C unless you qualify for and elect to be taxed under Subchapter S.
What’s needed to become an S Corp
Once become a corporation by filing your Articles of Incorporation with the state, you will need to file IRS Form 2553 if you want your corporation to be taxed under Subchapter S. The IRS rules state that an election is only considered effective in the current tax year if the Form 2553 is completed and filed any time before March 15th.
Generally, an election held after March 15th but before the end of the tax year only comes into effect for the next tax year. However, some states may also require you to file a state-level S corporation election after incorporating your business.
The Bottom Line
There is no ultimate option among the possible business structures and tax treatments. The choice you make should be based on your business-specific needs and direction. While you’re going through the process of business formation, the owners should cooperate closely with legal and tax consultants to choose the business structure that fits their needs and is ideal for business growth.
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