Choosing to structure your business as an S-corporation or C-corporation can be one of the most important decisions in your career. Your choice will have a major impact on several elements of your business, such as taxes, funding, ownership, and expansion. For most business owners, the first item on that list plays the biggest role in the decision.
In other areas, however, S-Corps and C-Corps are very similar. This guide explains the differences and similarities between the two options along with their advantages and disadvantages.
But first, let’s define what it means to be structured as a corporation in general:
What is a Corporation?
Establishing a business as a corporation means making the business a separate legal entity from its owners. Due to this separation, the owners of a corporation are not technically referred to as “owners” but “shareholders” or “stockholders.” They own shares of stock in the business, as opposed to owning the business itself.
Hence, shareholders do not make decisions in regards to management and company policy. These decisions are instead reserved for a board of directors, the members of which are chosen by shareholders. But when it comes to day-to-day operations, it’s the company’s officers – CEO, COO, CFO, etc. – who are in charge.
This is why shareholders are legally separate from all business activities, including sales, revenue, expenses, and liabilities.
Yes, the board of directors and officers do in fact have a tendency to clash.
What is a C-Corp?
A C-corporation is the default type of corporation. The definition of a C-corporation is essentially the same as the definition of a corporation in general, so the two terms can be used interchangeably. Most corporations are C-corporations.
As mentioned earlier, shareholders for a corporation are not personally liable for the business’s debts or obligations. In other words, shareholders cannot be personally sued by creditors, employees or customers for business-related issues.
This is very different from a sole proprietorship, which offers no legal protection for the business owner. Creditors can seize your personal assets if you don’t fulfill your obligations.
Corporation shareholders may receive dividends or shares of the corporation’s revenue and may also sell their shares for a profit or loss.
In terms of income taxes, corporations are taxed separately from their shareholders. However, if corporate income is distributed to the corporation’s shareholders as dividends, the shareholders would have to pay personal income tax on those dividends. We’ll delve further into that later on.
In order to establish a C-corporation, you must file articles of incorporation with the state in which the business is located. C-corporations must also adhere to numerous periodic obligations such as shareholder meetings, director meetings, fees, and issuing stock.
What is an S-Corp?
The “S” in S-corporation stands for Sub-chapter of S of the Internal Revenue Code, or tax code.
This section of the tax code deals with what are known as tax “pass through” entities, which is the main difference between C-corps and S-corps.
Since S-corps are categorized as pass through entities, the corporation’s profits and losses are reported on the shareholders’ personal tax returns. Rather than paying a corporate income tax, an S-corps’ shareholders only pay taxes on their allocated shares of the company’s income. In addition to losses, deductions and credits, the income is “passed through” to each individual shareholder on his or her personal tax return.
Therefore, shareholders of S-corporations do not receive dividends. Each shareholder is issued a Schedule K-1, which shows the share of the income he or she has received.
As for obligations like issuing stock and shareholder meetings, an S-corps must follow the same rules as an C-corps. An S-corp is a subset of a C-corp, so the set up starts the same way: filing articles of incorporation with your home state.
But, in order to establish a corporation as an S-corps, the corporation must also fill out an IRS Form 2335 and meet a number of requirements set up by the Internal Revenue Service (IRS). For example, the corporation’s shareholders must be US citizens or residents, and there can be no more than 100 shareholders.
Differences Between C-Corps and S-Corps
Before diving further into the main differences, let’s recap what we know so far. Establishing an S-corp undoubtedly requires more paperwork than a C-corp. Once you’ve filed your IRS Form 2335, you will most likely have to file more documentation for your state to be known as an S-corp for state taxes.
It’s also clear that the biggest difference between the two is how shareholders are taxed. The following sections will explain the advantages and disadvantages of this difference along with certain others.
Many C-corps were converted to S-corps solely to pay less taxes.
With a C-corps, the shareholders must file a corporate income tax return. If corporate income is distributed to shareholders as dividends, that money gets taxed as well. Thus, C-corps are vulnerable to what is known as “double taxation.”
The only C-corps that escape double taxation are operating at a loss or reinvesting their profits back into the business, rather than distributing dividends to shareholders. C-corps shareholders do not to pay taxes on wages and salary, which are considered deductible expenses. If the salaries are deemed “excessive” by the IRS, however, that money can be considered a taxable dividend.
With an S-corps, shareholders only have to pay taxes at their personal income tax rate. So, from the perspective of an individual shareholder, an S-corps will allow you to keep more money than a C-corps.
C-corps are much less restrictive than S-corps when it comes to ownership and expansion. There’s no limit to the amount of shareholders and classes of shareholders. The latter policy makes it possible for venture capitalists and angel investors to hold preferred stock in C-corps.
With an S-corp, on the other hand, there can only be one class of shareholder. All shareholders must also be US citizens or residents, whereas a C-corps can have foreign investors. Raising funds for an S-corp is therefore much harder than a C-corp.
If your long-term goal is to sell your business, a C-corp is most likely the better option. An S-corp can’t be owned by a C-corp, LLC, general partnership, or even another S-corp. On the contrary, a C-corps can indeed be owned by another C-corp, LLC and most types of trusts.
How The Trump Tax Plan Affects C-Corps and S-Corps
A central purpose of the Tax Cuts and Jobs Act (or the “Trump Tax Plan”) was to cut taxes for C-corps and S-corps. These cuts first took effect during this year’s tax season, when business owners and shareholders filed their taxes for 2018.
Here are the tax cuts for both options:
- The corporate income tax rate for C-corps decreased from 35% to 21%. This law has no expiration date.
- Owners of S-corporations and other “pass-through” entities (LLCs, sole proprietorships, etc.) will be able to deduct 20% of the income they received from their business on their personal tax returns. This law will expire in 2025, unless Congress passes an extension.
The new law certainly does provide the opportunity for C-corps and S-corps to pay less taxes. But it probably won’t affect anyone’s decision to choose a C-corp or an S-corp. The latter option is still considered the better choice for individual shareholders. However, that doesn’t mean you shouldn’t consult your business lawyer and accountant in order to be 100% sure about your decision.
C-Corp vs S-Corp Tax Example
Since taxes are the biggest difference between the two options, let’s take a look at a hypothetical scenario to see how much money a business would pay in taxes if it was a C-corp versus an S-corp.
The only figure you really need for this scenario is your taxable income. In order to figure out your taxable income, subtract your deductible expenses from the revenue you receive from your business.
Say, for example, you have a taxable income of $300,000.
If the business was a C-corp, you’d first have to apply that new 21% corporate income tax rate. That gives you $63,000. Most shareholders would likely claim all of that money as a dividend. The dividend tax rate is 15%, which leaves you with $9,450. Add that to your corporate tax of $63,000, and you’ve got a total tax bill of $72,450.
Now, let’s apply the same taxable income to an S-corp. According to the new tax law, owners of “pass-through” entities can deduct 20% of their business income before determining which tax rate to apply. That leaves you with $240,000 taxable income after the 20% deduction. The 2019 tax brackets put you in 35% range, which gives you a total tax bill of $59,689.50 for a single filer provided they had no other income for the year.
As you can see, the S-corp shareholder saves significantly more money than the C-corp shareholder. But this might not be the case for all businesses, so, once again, remember to ask your accountant or lawyer about how you’d fare with each option. For instance, a corporation with less profits might save more money if it was a C-corps.
Pros and Cons of Each Option
At this point, we’ve gone over all the important differences between a C-corp and S-corp. To help your decision, let’s break down all of the reasons someone would choose either option. The answer largely depends on your priorities, like saving money or selling the business.
- Less complicated: If you know the definition of a corporation, you know the definition of a C-corp. You don’t have to learn any new tax laws or fill out additional paperwork. There’s also no restrictions for expansion, so you don’t have to change your growth-related goals.
- Easier to raise venture capital: If raising money is integral for your business’s future, it’s hard to argue against structuring your business as a C-corp. Most venture capitalists and angel investors favor preferred stock, which is not an option for S-corps.
- Easier to sell your business: Most types of businesses can only own part of an S-corp, as opposed to owning the whole business. With a C-corp, almost every type of business can purchase the entire corporation.
- Easier to do business overseas: Unlike S-corps, C-corps can have foreign shareholders. Offering ownership to overseas shareholders can be a great way to begin doing business in their home countries.
- Higher taxes: In most cases, C-corps pay higher taxes than S-corps thanks to the “double taxation” rule. This means less net income for the company as a whole along with individual shareholders.
- No personal write-offs: C-corps shareholders are not permitted to write off business losses on their personal tax returns. What they can do, however, is deduct the cost of “fringe benefits.” This includes disability and health insurance. C-corps that offer the same fringe benefits to at least 70% of the company do not have to pay taxes on these expenses.
- Lower taxes: The advantage of avoiding double taxation, or having to pay two sets of taxes on the business’s income, cannot be emphasized enough. Individual shareholders make more money, as does the company as a whole. This can be massively beneficial for smaller corporations that are not seeking external funding nor looking to be bought out.
- Personal write-offs are permitted: S-corps shareholders can write off their business’s losses on their personal tax returns. Once again, this is particularly advantageous for younger, smaller corporations, which are typically not profitable for their first few years in business. Many S-corps shareholders use this rule to offset their income from sources outside of the corporation.
- More complicated: Establishing and maintaining an S-corp takes more time and effort than a C-corp. First, you have to learn all the new responsibilities and tax procedures associated with S-corps. Next, you have to file an IRS Form 2553 along with state paperwork. Once you’re in business, you must always make sure you are complying with regulations, such as the type of shareholders you can work with. Violating certain regulations could result in penalties and/or fines.
- Harder to do business overseas: All S-corps shareholders must be US citizens or residents. The inability to have foreign shareholders could make it difficult to do business overseas or reach your true growth potential.
- No preferred stock: If funding is a concern, it might be best to put S-corp aspirations on hold. S-corps cannot offer preferred stock and can only have one type of stockholder. All shareholders must adhere to the same regulations and essentially have the same role. Acquiring funding from venture capitalists and angel investors is therefore very difficult.
- Heavier penalties: The reward of paying less taxes comes with a higher risk of IRS penalties. If an S-corps and C-corps were to violate the same regulation, an S-corps might face a more severe penalty. The IRS may even terminate your S-corps status if you violate a key regulation, like the limit for number of shareholders.
Making Your Decision
One thing C-corps and S-corps have in common is the significance of their pros and cons. Certain advantages and disadvantages of both are huge enough to be deal-breakers. With startups, for instance, the top priority is often acquisition. Another business’s top priority might be minimizing tax payments, since high taxes can be a serious burden to growth. Some business owners might simply choose the simpler option, possibly because they have less time on their hands.
Also, don’t forget that other business entities can offer similar advantages to corporations. For example, an LLC can give you the best of both worlds. The ownership structure is easier to navigate than a corporation and there’s much less paperwork involved. But, you’d still pay considerably less taxes than a sole proprietor, and your personal assets would be safe in the event of a debt-related issue.
How to Set Up Your Business as a C-Corp or S-Corp
The process of establishing a C-corp and S-corp varies from state to state. In most states, the first step is to file articles of incorporation. Next, you’ll probably have to develop operating agreements, corporate bylaws, issue stock certificates to shareholders, and hold an initial board of directors meeting.
All paperwork must be 100% correct when forming a corporation. You can ensure accuracy with the help of a business lawyer, especially for articles of incorporation. Several software tools, however, greatly simplify the process of filing incorporation documents. Some business owners may be able to use these tools to file the documents on their own.
Still, you’re eventually going to need a good business lawyer for other purposes. This individual will go on to play an integral role in establishing your corporation and staying compliant with regulations. So, you might as well find a business lawyer as early as possible.
Additional S-Corp Paperwork
Depending on your state, the process of establishing an S-corp might require just one more step than a C-corp: the IRS Form 2553. If you are starting a new business, this form is due within 75 days of the company’s inception. If you are looking to convert an existing business into an S-corp, the deadline for this form is March 15. Since each state has its own S-corp requirements, you may have to file additional paperwork, and they may have separate deadlines.
Yes, it is perfectly feasible to revert an S-corp back to a C-corp. This is yet another task requiring the help of that handy business lawyer, along with your business accountant. After all, the only truly significant change will likely be the way the corporation pays taxes.
A Life Changing Decision
It’s understandable if you are still not sure which option makes sense for your priorities. You might not even be sure as to which priorities are most important. But choosing between a C-corp and S-corp is a life changing decision. There should be no doubt as to whether you’ve made the right choice.
Much like any other crucial business decision, you can only be certain of your choice after talking to the experts. So, talk to your business lawyer, accountant or tax attorney, even if you think the answer is fairly obvious. This is one of the few instances where it’s undoubtedly worth it to take every precaution in the book.