S Corp vs C Corp: What You Need to Know
Table of Contents
- What is an S Corporation?
- What is a C Corporation?
- The Difference Between C Corp vs S Corp
- The Similarities of C Corp and S Corp
- Which is Best Option for Your Small Business?
- Setting Up Your Business as an S Corp or C Corp
- Requirements to Form a C Corporation
- Requirements to Form an S Corp
- Final Thoughts
If you’re starting a new company or changing your business structure, one of the major decisions you need to make is to determine the type of business entity to form. Newly formed companies can choose from the following legal structures: sole proprietorship, partnership, S Corporation, C Corporation, and Limited Liability Company (LLC). Some business owners choose LLC, while others consider S corp vs C corp.
Choosing between an S Corp and a C Corp can significantly affect your company’s growth, future, and investor base. Unfortunately, there isn’t a one-off answer as to which structure is best. Entrepreneurs need to carefully assess and understand several variables that affect this decision.
What is an S Corporation?
As your business grows and becomes more complex, you may find proprietorships and partnerships less suitable. S corporations are a great choice for small- to medium-sized privately-owned companies that outgrew their current structure.
S corporation (S corp) stands for Subchapter S Corporation or Small Business Corporation. In an S corporation, the IRS grants a special tax status allowing corporations to pass corporate income, deductions, and credits to shareholders.
The shareholders will then divide the income/losses among themselves and report them on their personal income tax returns. Since S corporations do not pay income tax, they get to avoid double taxation or paying taxes twice from the same source of income (corporate level and business owner level).
Without the corporate tax, tax rates for S corporations are based on where the business owner’s personal income level falls within the tax bracket.
Remember that S corporations are not a type of business entity, but rather a tax designation. Businesses can’t ‘incorporate’ as an S corp. You need to apply to the Internal Revenue Service (IRS) to become one.
What is a C Corporation?
As your company continues to grow and becomes more complex, you may need to shift from an S corp to a C corp structure. You’ll know this if you have more than 100 shareholders or you need different share class structures. A C corp structure is the only entity that works for all large publicly traded corporations.
A C corporation is a structure wherein both shareholders and the business entities are taxed. The IRS and other tax companies consider corporations as separate taxpayers. Corporations pay corporate-level income taxes before they give out the remaining amounts or dividends to shareholders.
The shareholders will then pay taxes on the dividends they received. C corps have a special corporate tax rate that’s usually lower than individual tax rates. While double taxation isn’t ideal for business owners, being able to reinvest profits at a lower corporate tax rate offsets the cost.
The Difference Between C Corp vs S Corp
As you may have observed, the main difference between S corp and C corp is taxes. However, three primary factors that differentiate S corporations and C corporations from one another: formation, taxation, and ownership.
C corps are the default corporation; you’ll automatically become a C corp if you file articles of incorporation in your state. If you want to shift to an S corporation, you need to contact the IRS and file Form 2553. You may need to submit other forms to fully become S corp.
C Corp Formation
Since C corp is the default corporation, your company will immediately become a standard C corp if you file articles of incorporation to register your business. But even if C corp formations happen by default, it may not be the right option for every company. C corporations are for companies looking to further scale their operations. If you own a small business, you might benefit more from being an S corporation.
S Corp Formation
As mentioned, you need to file IRS Form 2553 to form an S corp. Once you’ve filed it, your company will become an S corp for federal taxes. To be recognized as an S corp for state-level taxes, you may need to file additional paperwork.
S corp and C corp both follow the same steps when it comes to corporate formation. You need to file articles of incorporation, choose a registered agent, and make corporate bylaws.
Forming an S corp takes more work than forming a C corp. You may need to file more documents to become an S corporation. Additionally, there may be different requirements depending on the state you’re operating in.
C corporations pay taxes twice: shareholders pay taxes on their dividends and the company pays corporate income tax. On the other hand, S corporations only get taxed once. Shareholders in an S corp report their company’s income and losses on their personal tax returns. This means that they don’t have to pay corporate-level taxes.
C Corp Taxes
If the charitable donations made to your business don’t exceed 10% of your company’s income, you can deduct 100% on your corporate tax return. However, the biggest drawback for C corporations is double taxation. You get taxed on your company’s revenue, as well as for personal returns. In other words, you’re losing money twice on the same source of income.
While bigger companies don’t bat an eye, smaller businesses take much of the blow. Small businesses don’t always have enough cash to get taxed twice. Whether you pay taxes on a corporate or personal level, your earnings take the hit.
Business owners often write off their personal taxable income to offset the expenses, but C corps don’t allow tax deductions for personal income tax returns.
S Corp Taxes
Compared to C corps, taxes are one of the primary advantages of S corporations. Many business owners, especially small businesses, structure their business as an S corp to save on money on taxes. Unlike a C corp, S corps only need to pay taxes once. Business owners can write off up to 20% of their business income on their personal taxes.
However, one of the cons of S corporations is that the IRS heavily scrutinize S corp tax filings than they do with C corps. If the IRS detects issues and errors with your taxes, they could cancel your S corp status.
Lastly, S corp and C corp both differ in the restrictions on ownership. C corporations don’t have a lot of limitations when it comes to ownership. C corps also offer more flexibility if you want to expand or sell your business to another company. Anyone can be a corporate owner and there’s no limit to the number of owners your company has.
On the other hand, all S corporation owners should be U.S. citizens and the number of shareholders should not exceed 100.
S Corp Ownership
S corporations are a better option for business owners who want limited ownership. As mentioned, the shareholders should not be more than 100 and all of them have to be U.S. citizens. Additionally, S corps only allow one type of stock while C corps can have several. This limitation could hamper the growth of your business, especially for companies with high growth potentials. Since the IRS pays more attention to S corporations, breaking these restrictions could mean losing your S corp status.
Other S corps, LLCs, trusts, or C corps cannot acquire an S corp. If you want to sell your business, you may need to shift to a C corp.
C Corp Ownership
C corporations have no ownership issues. It’s a great option for business owners who plan on selling their company or adding more investors in the future. With a C corp, you can sell stocks to potential investors because you can have an unlimited number of shareholders.
While C corporations don’t have ownership restrictions, you still need to properly manage your business. You need to issue stock to shareholders and you may need to hold meetings with both the shareholders and the board of directors. Additionally, you may need to pay certain fees to retain your C corp ownership status.
The Similarities of C Corp and S Corp
Now that you know the difference between the two, it’s time to learn about their similarities. S corporations and C corporations share four different characteristics:
- Filing Documents
- Limited Liability Protection
- Corporate Formalities
- Separate Legal Entities
1. Filing Documents
Whether you’re filing for an S corp or a C corp, the documents needed are the same. Even though you S corporations need more paperwork, the articles of incorporation for both corporations require similar documents.
2. Limited Liability Protection
Both S corporations and C corporations benefit from limited liability protection. With this feature, shareholders are not financially responsible for the company’s debts or financial obligations. In other words, you don’t have to pay out of pocket for financial responsibilities or debt incurred by your company. However, this isn’t the case for sole proprietorships.
3. Corporate Formalities
S corporations and C corporations are similar when it comes to compliance responsibilities. Corporate formalities both S corps and C corps need to follow include issuing stock, adopting bylaws, holding shareholder and director meetings, filing annual reports, paying for yearly fees, and maintaining a registered agent and office.
4. Separate Legal Entities
Whether you’re an S corp or a C corp, you can use separate legal entities. Being legally separated from your business ensures that you are not personally liable if anything were to happen to your company.
Even though S corp and C corp shareholders own the company, they don’t make the decisions. The shareholders elect a board of directors to handle management and policy issues. On the other hand, the day-to-day operations are handled by the officers of the corporation, such as the CEO, COO, and CTO.
Which is Best Option for Your Small Business?
There’s no easy answer as to which structure is the best for your company. You need to thoroughly assess your business, including your goals, finances, and more. To help you decide, here are some of the factors you need to consider:
1. The Double Taxation
The double taxation is a major differentiator between S corporations and C corporations. As mentioned, C corps are taxed twice – as a corporation and as a shareholder. If you don’t mind double taxation, then you might want to consider a C corporation. On the other hand, S corporations are for companies that prefer to save money on taxes.
2. Future Acquisition Plans
C corporations are better for business owners looking to sell their company in the future. Unlike S corps, C corporations can be owned by different types of business structures, making acquisitions easier should you decide to sell your company. Additionally, C corporations can have as many owners and shareholders as you’d like.
3. Number of Shareholders
Some small businesses aren’t fit for full-scale expansions; in fact, many of them want to stay small. S corporations only allow, at most, 100 shareholders and they have to be U.S. citizens. However, keep in mind that S corporations pay close attention to shareholder input.
If you’re expecting a significant business growth in the future, you might benefit more from a C corporation structure.
4. The Extra Scrutiny
When you file your articles of incorporation, your business will immediately become a C corporation. To shift from a C corp to an S corp, you need to submit additional documents. Other than that, the IRS heavily scrutinizes S corporations. You need to keep a clean record; otherwise, one mistake could mean losing your S corporation status.
If you don’t mind the extra scrutiny along with the other factors, an S corporation may be a better solution. On the other hand, if you think you can’t keep up with S corporation requirements, try becoming a C corp.
5. Other Options
S corporations and C corporations aren’t the only options for your business. If neither of those work, here are some of the ways you can set up your business:
- Sole Proprietorship: This is the most common type of business structure where only one person (aka a sole proprietor) owns and operates the business. It’s a great option for small businesses that prefer complete control of their business. However, as a sole proprietorship, you don’t separate your personal and business entity. You include your business expenses and personal income on your personal tax report. So if your business accrues debt, you’re responsible for repaying it.
- Partnership: A partnership happens when two or more people own a business. There are two different types of partnerships: general partnership (both partners own and manage the business and have equal shares of profits and losses) and limited partnership (partners serve as investors and do not have business decision rights).
- LLC: A limited liability company (LLC) separates your business and personal liabilities. This means that owners are not liable for any business debt. Structuring your company as an LLC protects you from potential lawsuits and increases your chances of securing funding in the future.
Setting Up Your Business as an S Corp or C Corp
After you’ve reviewed your options and weighed the pros and cons, the next step is to set up your business. For S corps and C corps, the steps vary depending on the state your business is in.
Generally, you start the process by choosing your business’ name and filing articles of incorporation. You also need to draft corporate bylaws, set up a meeting with the board of directors, and issue stocks to your shareholders.
There are online legal services that can help you file incorporation documents. However, it’s best to hire a reputable lawyer to help you set up your business.
Requirements to Form a C Corporation
If you’ve decided to stick with a C corporation, here’s what you need to do:
- Pick an appropriate business name based on the corporate naming guidelines specific to your state.
- Obtain an employer identification number (EIN) or another similar tax ID number.
- Choose the board of directors of your C corporation.
- File articles of incorporation to officially register your C corp. Keep in mind that you need to pay a filing fee of $100 to $800 for the paperwork. This fee will depend on the state you’re incorporating in.
- Issue stock certificates to the shareholders of your C corporation.
- Get the required licenses and permits specific to your business.
Requirements to Form an S Corp
If you think an S corporation suits your business, here’s what you can do to become an S corp:
1. Be a C Corporation or an LLC
As mentioned, before you become an S corporation, your business needs to be structured as a C corporation first. If you’re currently an LLC and you meet the criteria for S corporation, you can file for an S corporation status without becoming a C corp.
2. Determine if You Qualify for S Corp or Not
You need to meet the following requirements to become an S corporation:
- Your company should be located and operating within the United States.
- Allowable shareholders only – meaning shareholders should all be U.S. citizens and they should not be partnerships or other corporations.
- All company shareholders should agree to become an S corporation.
- A maximum of 100 shareholders.
- Your company should only have one type of stock. For instance, you can’t have a preferred stock system and a two-tiered common stock.
- Your business shouldn’t be an insurance company, bank, or a domestic international sales corporation.
3. File Form 2553
If your company passed the IRS’s requirements, the next step is to submit Form 2553, Election by a Small Business Corporation. All of the company’s shareholders should also sign the form.
Form 2553 has four different parts:
a. Election Information
This part requires you to fill out basic information regarding your business, such as the following:
- Name, address, date, and state of incorporation, and employer identification number for your company.
- The IRS will need to contact someone about your application. You can provide the name and contact information of a corporate officer.
- Tax details on the year you intend to become an S corporation.
On page two, you need to include the name, address, signature, and number of shares, and social security number of every shareholder who agrees with adapting an S corporation structure.
b. Selection of Fiscal Tax Year
In this part, you need to answer a few questions regarding your company’s business tax year.
c. Qualified Subchapter S Trust (QSST) Election Under Section 1361(d) (2)
This part of the form is only applicable to trusts applying to be an S corporation. You need information on the income beneficiary’s home and address, and social security number.
d. Late Corporation Classification Election Representation
This step is only applicable to businesses that are filing their applications past the IRS deadline. To qualify for S corporation within the same year you’re applying for it, you need to file Form 2553 within two months and 15 days after the beginning of tax year.
For instance, if you filed for incorporation on January 1, 2020, and you want to be taxed as an S corporation within the same year, you need to submit the form before March 15, 2020.
If you want to know more about Form 2553, here’s the IRS’s instructions.
For LLCs, file Form 8832 instead.
S corp vs C corp? Which is better for your business?
The answer to this question depends on numerous factors. You need to carefully examine, such as taxes, legal liability, flexibility, costs, and your company’s future needs.
The type of structure you choose will significantly impact your company – from taxes and opportunities to financing and growth potential. Be sure to choose a structure that provides the most benefits specific to your business. Weighing the pros and cons of S corp vs C corp will help you decide the best structure tailored to your unique business goals and needs. Once you’ve decided on a business structure, visit your state website and register your business.
Choosing between different business structures can be overwhelming and intimidating. It’s best to work with a professional or a business lawyer to help you get started.