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You’re ready to set up your company, but you’re not sure the best legal structure to pick; this is understandable. A business’s structure decides its tax structure. Plus, it determines the legal protection of you and your assets as an individual.
Two business structures to consider are the C Corp and the S Corp. The entities have several similarities but aren’t the same. The following is key information to help you make a decision one way or the other.
Main Differences: C Corp and S Corp
The main difference between C Corp and S Corp is the Internal Revenue Service. The IRS taxes each business entity differently. The formation of the corporate structures is different, so the ownership also varies.
Corporations are the original C Corp. Americans created the first corporations on United States soil in the 1790s. S Corps received approval for the first time in 1996. The push for the S Corp was tax-related. It’s a move that allows entrepreneurs another way to open and operate a business. The S Corp gets around the double taxation of the C Corp business entity and offers the benefits of a partnership.
For federal tax purposes, S Corp income, losses, and credits go through the shareholders based on their percentage stake in the corporation. Each member claims those finances on their income statements; this avoids double taxation.
A C Corp, on the other hand, is a taxable entity. It has shareholders, but income, losses, and credits do not pass through them. Every employee, including the owners, receives a salary and other compensation. Shareholders claim all compensation and other benefits on the personal income statement separate from the Corporation. The C Corp legal and accounting team file taxes on behalf of the corporation separately.
A Corporation issues dividends to shareholders, and the IRS taxes the dividends.
All corporations start as a C Corp. To become an S Corp; the shareholders must file Form 2553 with the IRS. It must also meet several requirements, including:
- Be a domestic corporation
- Include only allowable shareholders
- Have 100 shareholders or less
- Issues only one class of stock
- Be eligible for corporation status
To form a C Corp, the shareholders and business owners must:
- Pick a business name
- Appoint directors
- File the Articles of Incorporation
- Create the corporate by-laws
- Hold a board of directors meeting
- Issue stock
- Obtain business licenses and certificates
After submitting all paperwork, you must wait for approval from the corresponding government agencies. When approval arrives, you are on your way to forming a corporation.
Entity Formation: C Corp vs. S Corp
All corporations start as a C Corp after the formation process. To become an S Corp; the shareholders must file Form 2553 with the IRS. The S Corp must also meet several requirements, including:
- Be a domestic corporation
- Include only allowable shareholders
- Have 100 shareholders or less
- Issues only one class of stock
- Be eligible for corporation status
To form a C Corp, the process is a bit more straightforward. The shareholders and business owners must:
- Pick a business name
- Appoint directors
- File the Articles of Incorporation
- Create the corporate by-laws
- Hold a board of directors meeting
- Issue stock
- Obtain business licenses and certificates
After submitting all paperwork, you must wait for approval from the corresponding government agencies. When approval arrives, you are on your way to forming a corporation. However, there are advantages and disadvantages to each type of corporation that you should consider before starting the process.
Because all companies start as a C Corp, this is seen as an easier option. For an S Corp, you will need to file additional forms and paperwork in the formation process. Different states have different requirements, further complicating the process. However, S Corps have limited shareholders, which may be a good thing if you are interested in making employees shareholders or truly value your shareholders’ opinions and involvement.
Forming a C Corp is an easier process, as it requires less paperwork than an S Corp. That doesn’t mean it’s the better option for your business. Since not every company is looking to get funding or expand, you may be better off using this option if you have a bigger company or if you are interested in expanding your company in the future.
Taxes: C Corp vs. S Corp
Every business structure has a set of tax advantages and disadvantages that are important to understand before forming your corporation. The same goes for how different types of corporations are taxed.
The S Corp enjoys pass-through taxation, and this helps avoid double taxation. However, distributions reinvested into the corporation count as taxable income even though you don’t receive them.
C Corps face double taxation on shareholder dividends, but you can deduct 100% of charitable donations or up to 10% of your corporate income.
Both corporations enjoy a lower tax rate than the self-employed and sole proprietor, and there are many potential deductions your company can make come tax season.
To file taxes on behalf of the S Corp, you must ensure that you have the proper forms. Claim your income on Form 1120S, while form 941 handles employment taxes. For farm employees, use Form 943. Form 940 handles Federal Unemployment Tax (FUTA).
S Corp shareholders claim their income on Form 1040. Form 1040-ES handles estimated tax.
To file taxes on behalf of the C Corp, fill out Form 1120. Form 1120-ES deals with estimated taxes. Like the S Corp, Forms 940, 941, and 943 handle Corp C employment taxes, too.
Both corporation entities require the expertise of knowledgeable tax accountants to properly file taxes with the IRS.
Ownership: C Corp vs. S Corp
The S Corp and C Corp enjoy personal asset protection. In a litigious society, it’s worth protecting personal assets from lawsuits against the business entity. To maximize this protection, all shareholders must abide by the governing rules. As soon as a shareholder or business owner pierces the corporate veil, the individual becomes liable.
Ownership liability comes into the picture when the corporation is in debt and can no longer pay its creditors. A shareholder becomes personally liable for the debt if they pierce the corporate veil. Commingling business assets with personal assets is one way to pierce the veil.
If a judge finds that the corporate veil is pierced during litigation, the plaintiff can request the seizure of personal assets to receive debt payments.
An S Corp ownership structure is more straightforward than the C Corp. The S Corp can acquire 100 shareholders or less and issue one form of stock, common, while a C Corp issues both common and preferred stock.
S Corp requires all shareholders to either be U.S. citizens or a non-citizen resident alien. Non-resident non-citizens cannot be shareholders.
C Corps do not limit the number of owners and issues common and preferred stock. This means that C Corps are allowed to raise capital on a great scale that is almost unlimited.
While a C Corp structure is worthwhile for entrepreneurs who plan to sell the company in the future, it is also a capital-raising vehicle.
S Corps can raise capital through the issuance of stock, but only common stock. Most outside investors steer clear of common stock, so that’s why most S corps don’t seek to raise capital from outside investors through stocks (the 100 shareholder cap also plays into this).
Once the C Corp gets large in terms of shareholders, making decisions becomes more challenging. This is why it requires so many formalities such as a board of directors, shareholder meetings, and keeping minutes.
Main Similarities: C Corp and S Corp
The C Corp and S Corp are similar; each has shareholders and must pay taxes. The S Corp is a corporation with special tax status approved by the IRS. The special tax status helps S Corp shareholders avoid double taxation.
Each business entity must officially declare its existence by submitting the appropriate forms to the IRS and other government agencies. Attain the necessary business licenses and certificates, too.
Both corporations protect the individual through asset protection. It allows you to protect yourself and your assets from litigation against the corporation.
As a corporation, shareholders in the C Corp structure enjoy a lower tax rate than the sole proprietorship.
How To Pick Which One Is Best For Your Business
Both S Corp and C Corp offer tax advantages over a sole proprietorship. The disadvantages of each balance out the advantages. The result is one difference that may help you make your choice. An S Corp does not go public because the structure only allows 100 or fewer shareholders. A C Corp allows an unlimited number of shareholders. If you dream of taking your company public, plan for that future.
The amount of shareholders impacts raising capital, so entrepreneurs take companies public to raise capital. However, the S Corp limits this ability.
An S Corp can become a C Corp by simply revoking Form 2253 in writing with at least 50% shareholder approval. If plans change as a C Corp, it is possible to convert the C Corp to an S Corp. These changes do have tax implications. Consult with a tax professional before starting the conversion.
If you’re on the fence, you should always consider the future. You can start small with an S Corp and then scale up with a C Corp. An S Corp is one way to get your feet wet, while the C Corp is great for those who are ready to dive in 100%.
The Last Word
And that’s about on on C corps vs. S corps. Have questions? Feel free to drop us a line or contact your financial advisor to make the best decision possible.
Filed under: Advice Columns
