Business owners have two different options when it comes to forming a corporation. Deciding between an S corp vs C corp can be tricky because there are many considerations beyond taxation.
To choose the right structure for your business, this guide will help you understand the key differences worth evaluating. We will also touch on how to move forward with the formation process once you have reached a conclusion.
What exactly is a corporation?
A corporation is a legal entity that operates under its own rules and is regarded as separate from its owners. And according to the law, a business possesses many of the same rights as a person. Corporations have the legal capacity to lend and borrow money, file and respond to lawsuits brought against them, enter into contracts, possess assets, recruit personnel, and pay taxes.
Both S corps and C corps get their names from the Internal Revenue Code (IRC) sections that govern how they are taxed. Subchapter C addresses the taxation of C corporations, and Subchapter S deals with the taxation of S corporations.
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Tax treatment of an S corp vs C corp
When forming their companies, most small business owners choose between S corporations and C corporations based on how they want to be taxed at the federal level. This is because the corporate business structure can affect both your personal income taxes (as the business owner) and the business taxes that the company itself pays.
S corporations are subject to pass-through taxation. This means that the business itself does not pay any corporate income taxes. Instead, the business’s income or losses are “passed through” to its shareholders. The shareholders then report this information on their personal tax returns. S corporations still file IRS Form 1120S, which includes both an income statement and a balance sheet. However, this documentation is for informational purposes only.
C corporations, on the other hand, are treated as distinct tax entities. They pay corporate income taxes on their earnings. And if the corporation distributes these earnings to its shareholders in the form of dividends, the shareholders must then pay personal taxes on the dividends they receive. So, in a sense, C corporations are subject to double taxation—once at the corporate level and again when shareholders pay taxes on their dividends.
Looking beyond tax advantages
| S Corporation | C Corporation | |
|---|---|---|
| Tax Treatment | Single taxation | Double taxation |
| Tax Benefit | Less self-employment tax | Lower maximum rate |
| No. of Shareholders | Maximum of 100 | Unlimited |
| Type of Shareholders | Strict limitations | No restrictions |
| Types of Shares | Only one class | Multiple classes allowed |
| Tax Filing | Quarterly | Annually |
From a tax perspective, an S corporation can save you money because you only have to pay taxes once (on your personal tax return). And although the conversation often ends there, the decision is not quite that simple.
The S corporation status also has some potential disadvantages and limitations. And C corporations offer certain benefits that can be appealing, particularly to growing businesses. The following sections will explore some of these key considerations in more detail.
S Corp vs C Corp: Advantages
Here is a simple overview of the primary advantages of S corporations and C corporations:
Common advantages
- Corporations protect shareholders’ investments. Shareholders are not liable for commercial debts without a personal guarantee. Creditors cannot seize shareholders’ homes, bank accounts, or other assets to recover company debts.
- Taking the time to form a corporation demonstrates to prospective clients, employees, vendors, and partners that the owners of a new company have made a serious commitment to the enterprise. Operating as a corporation rather than a sole proprietorship or partnership may benefit the credibility-building efforts of a newly founded company.
S corporation advantages
- S corporations are exempt from paying federal taxes, and most states recognize the federal S corporation election. Instead of being recognized at the corporate level, profit is sent to shareholders who are taxed on their personal income tax returns. In this same way, losses can be passed through to shareholders which can be especially advantageous during the startup process.
- Shareholders of an S corporation can work for the company, take salaries, and receive dividends. In fact, these dividends are tax-free dividends up to the value of their investment in the corporation. Owner-operators can also decrease their self-employment tax burden by classifying some of their income as dividends.
- Ownership stakes in an S corporation can be freely sold or transferred without any negative tax repercussions.
- C corporations are required to use accrual accounting unless they qualify as “small corporations” under the IRS’ gross receipts test. S corporations, on the other hand, can use cash accounting unless they have inventory.
C corporation advantages
- C corps allow an unlimited number of shareholders. This is an especially important consideration for businesses that aspire to be publicly traded on the stock market.
- There are no ownership limitations for C corporations. As a result, anyone can own shares, including business entities and non-U.S. citizens. This greatly simplifies the process of raising funds and acquiring equity financing.
- There are no limitations placed on classes of shares. A C corporation can issue more than one class of stock, allowing for differences in dividend and voting rights.
- C corps enjoy a reduced maximum marginal tax rate. The Tax Cuts and Jobs Act of 2017 reduced the corporate income tax rate to a flat 21% and eliminated the alternative minimum tax. This rate is significantly lower than the maximum personal tax rate, which is presently 37%.
S Corp vs C Corp: Disadvantages
While S corps and C corps have their advantages, both structures also have drawbacks that should be discussed. Here are the primary considerations for each:
Common disadvantages
- The incorporation process can be quite involved. You need a registered agent, articles of incorporation, and bylaws to form an S or C corp. Many states require additional reports and fees for corporations. These costs are usually inexpensive and you can deduct them as a cost of doing business. Still, they typically exceed the cost of forming and maintaining a sole proprietorship or partnership.
- A limited liability company (LLC) is simpler to manage than a corporation. Management of a corporation must adhere to extra formalities, like shareholder and board of director meetings, under corporate law. These meetings may require giving proper notice and taking minutes.
S corporation disadvantages
- If there is an error in the filing, election, consent, notification, or stock ownership requirements, a company’s S corporation status can be terminated. This would convert the entity into a Subchapter C taxpaying organization. While this issue is reversible, it is a risk not present with other classifications.
- S corporations must use a calendar year as their fiscal year unless they have a specific business reason not to. C corporations do not face the same limitations.
- S corporations can only have one class of stock. This prevents certain investors from receiving superior distribution or voting rights.
- S corporations can have at most 100 shareholders. These shareholders must all be U.S. residents or citizens, with few exceptions.
- Due to tax incentives to misclassify shareholder payments (as either dividends or salaries), S corporations face elevated scrutiny from the Internal Revenue Service.
- Employee shareholders who own more than 2 percent of the company are required to report and pay taxes on any fringe benefits, which are treated as compensation.
C corporation disadvantages
- The primary drawback of a C corp is double taxation. These companies must file their own tax returns and pay corporate tax on their business income. And if the company then declares dividends to shareholders, the recipients must report and pay taxes on the dividends as well. Depending on the business structure, this can be an inefficient way to distribute profit.
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Picking an S corp vs C corp: Which is right for your business?
Your choice of business entity will affect many elements of your company, including taxation, financing, and corporate governance. Therefore, it is crucial to select the corp status that best aligns with your business goals.
By revisiting the pros and cons of the two types of corporations, you should be able narrow the decision down to a few relevant considerations.
For example, if you are an aspiring small business owner who wants to limit your overall tax burden, an S corporation could be the right choice. But if you plan to raise money from investors or create multiple classes of shares, a C corporation may be the better option.
If you are still unsure of how to move forward with your company, consider speaking with a business attorney or legal agency. After reading this article, you will be able to ask pointed questions and more quickly understand their advice.
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Final thoughts
The S corp vs C corp debate is a complex one with many factors to consider. By taking the time to evaluate your business goals and consider the key differences between the two types of corporations, you are in an excellent position to form your company.
And if you are short on ideas on what to launch, we have got you covered there too! Check out this list of potential software businesses and this roundup of more approachable side hustle opportunities.
Corporation FAQs
The process of forming a corporation differs slightly from state to state. To start, register the company name and file articles of incorporation with the appropriate state agency. Then, create corporate bylaws, call a board of directors meeting, and distribute stock certificates to investors. For assistance throughout the process, consult with LegalZoom or IncFile. Both companies provide direction, guidance, and support at a very reasonable rate.
To switch from C corp to S corp status, you must meet all eight requirements summarized here. If your business is eligible, simply file IRS Form 2553. This form must be signed by all stockholders and submitted within two months and fifteen days after the start of the tax year. Otherwise, the election will apply to the following tax year.
Within 60 days, the IRS service center will notify the corporation if the election was accepted or not. If you do not receive a ruling letter in that timeframe, call the IRS at 1-800-829-4933 for more information.
C corporations can have multiple classes of stock, an unlimited number of shareholders, and even owners from other countries. These freedoms allow businesses to raise funding and distribute profits freely. S corporations, on the other hand, offer certain tax advantages and are ideal for smaller domestic companies that plan to treat all their owners equally.
