Starting a new business involves many important decisions, one of the biggest being which corporate structure to adopt. The two most common options for small businesses are S corporations and C corporations, each with their own set of pros and cons. Choosing the right structure can have major implications for liability protection, taxation, fundraising, and more. This comprehensive guide examines the key differences between S corps and C corps to help you determine which is better suited for your small business.
What is an S Corporation?
An S corporation is a legal corporate structure that provides pass-through taxation and limited liability protection to its shareholders. The "S" stands for Subchapter S of the Internal Revenue Code, which grants this special tax status. To qualify as an S corp, a business must:
Be a domestic corporation with 100 or fewer shareholders
Have only one class of stock
Only have shareholders who are individuals, estates, certain trusts, or certain tax-exempt organizations. Partnerships, corporations, and nonresident aliens cannot be shareholders.
S corps pass all business income, losses, deductions, and credits through to the shareholders' personal tax returns. The business itself does not pay federal income taxes. Shareholders must report their share of these items on their personal returns, paying taxes at their individual income tax rates.
This pass-through tax treatment is the defining feature of S corporations versus C corporations.
Other S corp characteristics include:
Limited liability protection for shareholders
Operational flexibility without the need for shareholder meetings and other formalities
Ability for shareholders to actively participate in management and operations
Relatively simple tax compliance and record-keeping
What is a C Corporation?
A C corporation is the standard or default corporate structure. Unlike S corps, C corps are considered separate tax entities from their owners. Key features include:
No limit on number of shareholders
Can have foreign investors, public investors, business entities as shareholders
Double taxation - C corps pay taxes on corporate income and shareholders pay taxes on dividends
More complex tax compliance and record-keeping requirements
Formal requirements like shareholder meetings and board of directors
Provides limited liability protection for shareholders
C corporations offer complete limited liability, but the double taxation generally makes them less appealing for small businesses. However, they may better facilitate attracting outside investors and going public in the future.
S Corp vs C Corp Tax Differences
The biggest consideration between S corps and C corps is taxation. Let's take a deeper look at how they compare:
S Corporation Taxes:
Income, losses, deductions, and credits "pass through" the business and are reported on shareholders' personal tax returns
No double taxation - business income is only taxed once at the shareholder level
Shareholders pay taxes on their share of income at their individual income tax rates
Business profits are taxed whether distributed to shareholders or retained within the company
C Corporation Taxes:
C corps pay corporate income taxes on profits at tax rates up to 21%
Shareholders also pay taxes on dividends they receive, usually at 15% or 20% capital gains rates
Double taxation means profits can be taxed twice - once at the corporate level and again if distributed to shareholders as dividends
Businesses can retain earnings within the company to defer shareholder taxes
As you can see, C corps result in two levels of taxation while S corps provide pass-through taxation. For most small businesses, pass-through treatment provides major tax savings versus C corp double taxation. However, businesses expecting to reinvest most profits may defer shareholder taxes with a C corp. Professional tax advice is recommended to determine the best structure based on your specific situation.
S Corp vs C Corp Differences | S Corp | C Corp |
Formation Process | File articles of incorporation with the secretary of state. File IRS Form 2553 to elect S corp status. | File articles of incorporation with the secretary of state |
Taxation Method | Pass-through taxation to the shareholders. | Potential for Double Taxation |
State Taxation | Varies by State | Obligation to file state income tax returns |
Shareholder eligibility | Individuals, Trusts, Estates, but not corporations, partnerships, or nonresident aliens | Accommodates a diverse range of shareholders |
Shareholder limits and stock classes | Limited to 100 Shareholders, single stock class | Unlimited shareholders, multiple stock classes |
Distribution of Profits and tax obligations | Mandatory annual distribution of income and deductions | Flexibility in profit distribution and reinvestment of earnings |
S Corp vs C Corp Ownership Differences
In addition to tax considerations, eligibility requirements for shareholders also differ between entity types:
S Corporation Ownership:
Limited to 100 shareholders or less
Shareholders must be U.S. citizens or resident individuals, certain trusts and tax-exempt organizations
Can only have one class of stock
Ownership can be transferred by selling or gifting shares
Family members or other businesses/entities cannot be shareholders
C Corporation Ownership:
No limit on number of shareholders
Ownership open to U.S. and foreign individuals, corporations, partnerships, private investors, venture capital firms, etc.
Ability to issue multiple share classes
Ownership interests can be traded publicly or transferred more freely
Greater flexibility for estate planning
C corps allow small businesses to attract outside investors and have flexibility if going public in the future. But the ownership limitations for S corps aren't prohibitive for most small or family-owned businesses.
S Corp vs C Corp Startup Differences
When starting a new business, forming an S corp involves a few extra steps versus a standard C corp:
Form corporation in compliance with state laws
File S corporation election with the IRS to receive pass-through tax status
Draft shareholder and corporate bylaws reflecting S corp requirements
Issue shares to initial shareholders
C corporations simply need to incorporate under state laws. The relative simplicity can be appealing for brand new businesses still sorting out details of their operations. However, filing Form 2553 (to elect S corp status) is not overly complex either. It mainly involves submitting it along with your incorporated documents.
Both S corps and C corps require adopting formalities like director/shareholder meetings, bylaws, stock ledgers, and corporate resolutions. Proper documentation and records retention helps ensure favorable liability protection. An S corp election also limits business structure changes going forward. Weighing these factors upfront will help avoid unnecessary tax and legal hurdles down the road.
S Corp vs C Corp Liability Protection
A major advantage of both corporate structures is that shareholders have limited personal liability for business debts and claims. Provided formalities are followed, shareholders' personal assets are generally protected beyond their investment in the company. A few liability considerations for each structure:
S Corporations:
Limited liability for shareholders
Active shareholders open to liability for personal actions or guarantees
Failing to meet S corp eligibility could forfeit liability protection
C Corporations:
Complete limited liability for shareholders
Passive investors insulated from any personal liability
The liability shield is a bit lower for S corps but still adequate for most small businesses. Extra steps like insurance and indemnity agreements can further limit shareholder risks. But consult an attorney to ensure proper protections are in place.
S Corp vs C Corp Costs
Both entities come with formation and ongoing compliance costs. Expect to spend $500 to $2,000+ to incorporate and elect S corp status. Budget for the following costs:
S Corporation Costs:
State filing fees to register corporation
Legal/accounting fees to draft and file S corp election
Annual state registration and franchise fees
Accounting for tax compliance and financial statements
Additional payroll, HR costs if more than owner-employees
C Corporation Costs:
State filing fees for incorporation
Legal/accounting fees for corporate bylaws and share issuance
Annual state registration and franchise fees
Accounting fees for tax compliance and mandatory audited financial statements
Payroll, HR, insurance costs
C corps generally have more extensive record-keeping and compliance costs. But an S corp with employees or certain ownership changes can have comparably complex requirements. While less rigid, properly maintaining an S corp as limited liability company requires an ongoing investment.
S Corp vs C Corp Conversion Process
One advantage of starting as a C corp is the ability to later elect S corp status if it becomes beneficial. However, tax implications must be carefully navigated when switching structures:
C Corp to S Corp Conversion Process:
File Form 2553 to elect S corp status within 2 months and 15 days of the beginning of a new tax year
C corp is taxed on built-in gains (unrealized asset appreciation) at time of conversion if sold within 5 years
Net passive income could be subject to additional corporate level taxes for three years post-conversion
Some tax planning strategies can help minimize conversion costs
S Corp to C Corp Conversion Process:
File a revocation of S corporation election
Much simpler than C to S conversion, but you must wait 5 years to re-elect S corp status
No transition tax implications
While not excessively difficult, tax planning should be part of converting a C corp to an S corp. Convert too early and you squander C corp benefits. Wait too long and conversion taxes eat into savings. Consult a savvy tax advisor to determine optimal timing.
S Corp vs C Corp: Which is Better for Small Businesses?
With a good understanding of the comparisons, deciding between an S corp vs C corp comes down to weighing a few key factors:
Tax treatment - Single vs double taxation
Ownership restrictions - Limits for shareholders of S corps
Liability protection - Slightly lower for S corps but still adequate
Eligibility for tax incentives - Some benefits different for each structure
Costs and accounting needs - Generally more for C corps
Long term flexibility - C corps easier to take public or adapt to changes
For most small businesses, especially those looking to reinvest earnings, the pass-through taxation of an S corp is hugely beneficial. The eligibility criteria are not very limiting for private ownership. And liability protection remains strong. While C corps offer more future flexibility, an S corporation election can be reversed if needed.
That said, here are instances where a C corp could be preferable:
Seeking venture capital or private investors
Likely to go public within a few years
Business will distribute most earnings as dividends
Significant losses expected early on
Prefer less ownership restrictions
Consult trusted legal and tax advisors to objectively weigh your situation. While an S corp makes sense for most small businesses, don't just default to it without considering your aspirations. Take time to make an informed decision when starting your company.
Frequently Asked Questions
Some common questions when deciding between S corps and C corps:
What is considered a small business for tax purposes?
The tax code doesn't specify a definition, but most companies with under 100 employees and less than $10 million in gross receipts are considered small businesses. Various incentives like tax breaks and government contracts use similar criteria.
How many owners can an S corp have?
S corporations allow up to 100 shareholders. Spouses count as one shareholder. Entity types like corporations and partnerships cannot be shareholders. C corps place no limits on number or types of shareholders.
Can I pay myself a salary in an S corp?
S corps must pay reasonable salaries to employee-shareholders before distributing remaining profits as pass-through income. Any salary Should be commensurate with duties and industry norms.distributions not classified as wages/salaries may be subject to payroll taxes.
What are the state filing requirements for S corps?
S corps are formed under state corporation laws and require articles of incorporation and bylaws. You must register annually and file the S election with your state. Some states charge annual franchise fees. Stay current on all state requirements.
Can I convert an LLC to an S corp?
Yes, LLCs can elect S corp status for federal tax purposes by filing Form 2553. You get pass-through taxation while retaining the limited liability benefits. Some formalities like shareholder agreements should be adopted. Consult an attorney when converting.
How do I file taxes for an S corp?
Shareholders receive K-1 forms detailing their share of corporate income/losses. This gets reported on their personal returns along with wages. The S corp files Form 1120S as an informational return but doesn't pay entity level taxes. Use an experienced tax preparer.
Is a C corp subject to self-employment tax?
Pass-through income to active S corp shareholders is subject to 15.3% self-employment taxes on the first $147,000 (2023). C corps pay employer payroll taxes on wages. But only C corp dividends are exempt from self-employment tax.
What are qualified and non-qualified S corp dividends?
Non-qualified dividends are treated as compensation and subject to payroll taxes. Qualified dividends are distributions of previously taxed income. They bypass payroll taxes but remain taxable to shareholders. Proper classification of dividends is crucial.
Deciding S Corp Vs C Corp
Choosing an S corporation or C corporation structure should not be done lightly when forming your business. Take time to fully understand the tax and legal implications. An S corp offers pass-through taxation and limited liability while only requiring minimal formalities. But C corps provide more long term flexibility for growth or an ownership change. Consider your business objectives and risk tolerance before deciding.
Most small businesses opt for S corp status to take advantage of pass-through taxation. This prevents double taxation but requires diligent compliance. Seeking experienced legal and tax guidance is highly recommended when making this important decision. The team at United Tax can provide tailored advice on whether an S corp or C corp is better for your unique situation. Contact us today to discuss incorporation planning for your business!
