S-Corp vs. C-Corp: A Guide for New Businesses
Once you have decided to incorporate your business, you will have the task of deciding how you want your business to be taxed, as an S-Corporation or a C-Corporation.
This decision will have a serious impact on not only how you pay taxes but also on your ability to scale your company. It is not a decision to be taken lightly.
Even if you elect S-Corp treatment, you must register your company as a C-Corp first.
In other words, the C Corporation is the underlying legal entity for both corporate structures. An S-Corporation merely denotes the tax status of your company.
However, because the IRS imposes certain regulations on companies in order that they qualify for S-Corp treatment, C and S-Corps function differently.
You should take some time to understand the pros and cons of each tax status before you dive in—this means learning more about what each type of corporation can do for you, both from an individual and a business standpoint.
C Corporation Basics
C-Corporations are traditional corporations. Although the rules governing this legal entity have evolved over time, they have been around since the first decade after the Revolution, forming the backbone of American enterprise.
The most important feature of American corporations developed after the passage of the Fourteenth Amendment in 1868. Using the language of the Amendment, companies began petitioning the court to be treated as individuals.
Over time, the Supreme Court has by and large granted corporations most of the protections that people have, including the right to make campaign donations, claim personal tax deductions, and exclude services for religious reasons.
The way corporations are taxed reflects this trend as well. They are treated as a separate entity by the IRS and must file their own taxes. At the same time, some corporate profit is taxed again, at the shareholder’s marginal rate, when it is distributed as earnings each year.
This feature of C-Corporations is called double-taxation.
Other main features of C-Corps are as follows:
- They are owned by shareholders, not necessarily the CEO or founder.
A general partnership or LLC is owned by the same people who run the company. Not so with a corporation. In a corporation, the founder may choose to retain a controlling interest in the company by holding at least 51 percent of the stock. Or she might give up the controlling interest or divide it equally among a group of corporate partners.
- They can grow almost indefinitely and have global reach.
A C Corporation can operate anywhere in the world, and in as many international locations as it wants. There is no limit on the number of shareholders the company can have, nor are C-Corporations limited in the number of classes of stock they can issue.
- They must file articles of organization with the secretary of state where they register the company.
Articles of organization set forth the corporate structure, naming a board of directors, who then elect officers to serve various roles in the company.
- They are not a personal liability for their owners.
Legally, corporations are responsible for any damages they incur, including debt and any payments resulting from a lawsuit.
The IRS keeps a close eye on corporations to make sure that they don’t mingle personal and corporate assets, which constitutes fraud under the law. This is called “piercing the veil.” It’s important to note that every state has a slightly different view of what it takes to pierce the corporate veil.
- They are accountable to the public for their actions.
Corporations must hold an annual meeting and publish an annual report each year in order to maintain good standing.
- They are taxed at a lower standard rate and eligible for numerous tax breaks.
Double-taxation can hurt the principal shareholders in a C-Corporation. However, there are also a number of opportunities to minimize the tax burden of double-taxation, including corporate salaries, rents, depreciation, repairs and maintenance, charity donation, and employee compensation packages.
S Corporation Basics
The primary function of an S-Corp is to establish pass-through taxation for a company that would otherwise be taxed as a separate entity.
Simply put, this means that the onus of paying income tax falls to the company’s individual shareholders. Company profits and losses are not subject to taxation at the corporate level—rather, they are passed on to the shareholders, who are required to report them on their personal returns.
Establishing an S-Corp is something you will do after you have already established your C-Corp. Once you have registered your C-Corp and paid all applicable fees, you must file form 2553 with the IRS, which is an intent to receive S-Corporation treatment. This form must be filed no later than 75 days following the finalization of your C-Corp status.
Some companies tend to benefit more from being an S-Corp than others. This is due to the various eligibility restrictions imposed upon S-Corporations.
These restrictions include:
- You must be a U.S. citizen.
In order to establish or be a shareholder in an S-Corporation, you must be a citizen or legal resident alien of the United States. Foreign entities are not allowed to be an S-Corp.
- You cannot have more than 100 shareholders.
In addition to this limit on the amount your company can grow and still be taxed as an S-Corp, you are also limited as to who can be a shareholder. Only individuals, estates, and certain forms of tax-exempt trusts and entities can become S-Corp shareholders.
This is very different from a C-Corp. Not only can you have as many shareholders as you want; other businesses and foreign entities can become shareholders in your company
- You can only have one class of stock.
The IRS also limits S-Corps to one class of stock. Ordinarily, state law gives corporations the right to issue various classes of stock that give shareholders different voting rights and means of receiving dividend payouts.
S corps can only issue one class of stock, giving all shareholders the same preferences regarding dividend distribution. However, you can still allocate different voting rights to shareholders.
Biggest differences between C-Corps and S-Corps
There are three main differences between S-Corps and C-Corps:
1. They are taxed differently.
As a standard corporation, C-Corps are separate legal entities and subject to double-taxation, first at the entity level and then at the shareholder level when it distributes dividends.
Choosing S-Corp treatment for your business means you have elected to have pass-through taxation instead. That means you and other shareholders must place business losses and gains alongside other income on your personal 1040 form.
Until the Tax Cuts and Jobs Act of 2017 came along, it was reasonably simple to choose which of the two entities was more advantageous for a given business.
The Tax Cuts and Jobs Act introduces a new variable, however. Section 199A of the legislation provides a 20 percent deduction for qualified business income from pass-through entities, such as S-Corps, serving as compensation for the lower corporate tax rate the bill also implemented.
The language of 199A is highly complex, and you’ll need the help of tax or legal professional to see if your business qualifies for the deduction.. If it does, then it can lead to a significant reduction in your tax obligation.
2. C-Corps have more room for expansion.
C-Corps are not subject to the same restrictions on ownership as S-Corps are. Any person, partnership, corporation, or entity can own a C-Corp. S-Corp ownership, on the other hand, is limited to individual citizens of the United States or legal resident aliens.
The bottom line is C-Corps are designed for global expansion, and S-Corps are not. As a company grows, the owners may elect S-Corp treatment, only later to establish the business as a C-Corps.
3. There are limits placed on shareholders in an S-Corp.
Both types of corporation offer stock in the company to their shareholders, meaning that these shareholders essentially own the business.
S corps, however, are limited to no more than 100 shareholders and to one class of stock. This means, in an S-Corp, that all shareholders are have equal rights regarding the distribution and liquidation of stock shares.
It does not mean that all shareholders must have equal voting rights, however. Within the one class of stock, the founding members can still have voting and non-voting stock.
C-Corps, on the other hand, can divide their distribution and liquidation rights according to the type of stock their shareholders hold. These types of stock can be common stock or preferred stock, but there are several ways that these shares can be structured.
Dividing the stock into different classes makes it easier for the company’s executives to maintain control over the board of directors when making any important decisions. In most circumstances, a C-Corps’ founding members will hold the most sway when it comes time to vote, meaning they hold the reins where most business decisions are concerned.
C-Corp Pros and Cons
Depending on your vision for where your company is going, a C-Corp may or may not be advantageous.
The Positives to Running Your Company as a C-Corp
With the passages of the Tax Cuts and Jobs Act, the current administration established a flat tax rate for C-Corps that caps at 21 percent—which is much lower than the previous rate of 35 percent.
If your company is poised to scale, a C-Corp is probably the better choice as there are no limits as to how many shareholders you can have. Additionally, it is possible to attract foreign investment because there are no restrictions on who can own shares in the company. This may make it easier for you to raise money and it will also make your company more attractive when it comes time to sell.
Liability is limited in a C-Corporation, meaning that shareholders, directors, employees—all stakeholders, actually—are protected in case the company falls into debt or is involved in a lawsuit.
S corps and C-Corps share the advantage of perpetual existence. This means that even if the owner moves on or dies, the corporation will continue to exist in perpetuity.
The Negatives to Running Your Company as a C-Corp
Double-taxation, as mentioned above, could be a concern in a C-Corp. The company is taxed at the corporate rate and, when dividends are disbursed, shareholders pay taxes on that income as well.
It’s important to note that double-taxation is only an issue if a company’s stock distributes dividends to shareholders. Particularly in the early years of a company, operating costs and salaries may reduce the profit margin to such a small amount that the founding members need not worry too much about double-taxation.
In a C-Corp, losses cannot be written off by shareholders on their personal income tax returns. If your company is small, or in the early stages, this could be a significant deterrent to creating a separate legal entity.
The process of incorporation is both involved and expensive. There are a lot of state and federal regulatory compliance issues to pay attention to, and you must comply or you could either pay heavy fines to restore your good standing or lose your company’s legal status.
Let Filenow guide you, with our simplified incorporation process.
From a bottom-line standpoint, there are many advantages to being a C-Corp. Though you may pay more in taxes initially, you will be able to take advantage of a lower tax rate; you will also be open to a great deal more in terms of potential growth and investment.
S-Corp Pros and Cons
S corps, likewise, have their own pros and cons.
The Positives to Running Your Company as an S-Corp
- Pass-through Taxation
Taxation is pass-through, meaning your company will not pay corporate taxes and is not subject to double-taxation.
- 20 Percent Deduction on Corporate Profits
Shareholders in an S-Corp can deduct 20 percent of their business income on their personal income tax returns. They can also deduct business losses on their personal income tax returns.
This could be a major advantage during the first few years of doing business, as it is not uncommon for most startup companies to suffer through several months or even years of loss before seeing any actual revenue.
- Limited Liability
Shareholders, employees, officers, and directors are protected in the event that the company is involved in a lawsuit or is in debt.
- Exist in Perpetuity
As long as you register your company as a C-Corp (and not an LLC), it will continue to exist in perpetuity, the same as a c-corp. The S-Corp election does not change that fact.
The Negatives of Running Your Company as an S-Corp
- Restricted Ownership
Ownership is restricted to US citizens or legal residents. Corporations, partnerships, and foreign entities are not allowed to own stock in an S-Corp. This may limit your ability to seek investment over the long-term and it may impact your ability to do business outside of the United States.
- More Potential Scrutiny from the IRS
As an S-Corp, you may also be under more scrutiny, as far as the IRS is concerned. Miss a deadline, miss a payment, or fall short of your compliance obligations and you could be reduced to C-Corp status and take on the inherent tax burden that goes with it.
- Lots of Regulations
If you are a very small business—for instance, if it is just yourself and one or two others—the regulations may be more than you want to deal with. Additionally, if you envision your company growing beyond 100 shareholders, being an S-Corp will limit your ability to do that.
- Fewer Investment Opportunities
S corps cannot receive money from foreign investors, and because they are limited in several other ways, your company may be less attractive to venture capitalists and other investors.
The bottom line: If you are reasonable sure that your company will remain small and stay domestic, then an S-Corp can provide tax benefits, especially now that the government has incentivized pass-through entities with an additional tax break.
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