When it comes to launching a new business, there are a million and one things to take into account. As an accountant or financial professional, your clients approach you with all sorts of questions when it comes to incorporating their new business. Should I form an LLC? Is a sole proprietorship the best option in my situation? What are the tax implications of incorporating? Providing guidance can be overwhelming at times.

Without a doubt, though, one question in particular comes up on a regular basis. No matter what industry a client is working in or what size their business happens to be, it’s not uncommon to get the question: what’s the difference between a C corp and an S corp? And, as a follow up: which form of business organization is right for me in my particular situation?

Answering this question isn’t always easy. There are a ton of things to take into account when deciding what form of business organization is right for one of your clients: sole proprietorship, partnership, S corporation, C corporation, LLC, or anything else.

That said, there are some important differences between S corporations and C corporations, and understanding those differences will make it easier for your client (or you!) to decide which form of incorporation is the best for any given situation. That’s why we’ve put together this comprehensive guide. The goal of this guide is to help you understand what distinguishes a C corp from an S corp — particularly when it comes to taxes — and how to choose between the two.

Ready to learn more about these different forms of business organization? Let’s dive in.

What do S corps and C corps have in common?

Every form of business organization is different. Sole proprietorships are radically different from LLCs, for example. And, S corps and C corps have some important differences, too.

However, these two forms of business incorporation also have some things in common. Before we get into the important differences between the two of them, let’s take a moment to identify the ways in which they’re similar.

Here are some things that both S corps and C corps have in common:

How are S corps and C corps different?

Now that we understand a couple of the things that C corporations and S corporations have in common, let’s examine some of the ways in which they’re different.

Forming a Corporation: S corps vs. C corps 

The formation of a corporation can be a little confusing for those who are new to the process. Why? Well, for one thing, all corporations start as C corps. That’s right: whether you intend to form a C corp or an S corp, your business will start out as a C corp by default once you’ve registered your company with your Secretary of State. This is due to the fact that there’s no way to specify S corp or C corp status when you file with your Secretary of State: you have to do so afterwards. If you take no action, you corporation will be a C corp by default.

How do you become an S corp instead of a C corp exactly? You’ll have to file what’s called an “S corp election,” which is a one page document that you send off to the IRS. This can be done immediately, or much later on. In other words, it’s possible to run your business as a C corporation for a number of years, file taxes as a C corp, and later on decide to file an S election and change your business’s status. The opposite is possible, too: you can function as an S corp for years, and later change back to a C corp.

Filing an S corporation can be a bit overwhelming and complicated, as the IRS instructions aren’t the easiest thing in the world to decipher. An election is only considered “effective” for the current tax year if it was either:

In other words, it’s typically the case that an election made after the 16th day of the 3rd month of a tax year will not be effective until the follow tax year. There are exceptions to this rule, though. If you can demonstrate that your failure to adhere to this timeline was due to some reasonable cause, it’s possible for your filing to be effective as of the current tax year — even if it was filed outside of the normal date limitations.

Taxes: The Biggest Difference Between C corps and S corps

So, if you’re automatically a C corp by default when you incorporate at the state level with your Secretary of State, what exactly is the reason for opting to file an S corp election with the IRS and make the switch from C corp to S corp? There are other differences between the two organizational types, but the biggest and most fundamental one in the eyes of business owners is pretty clear: taxation.

C corps and S corps are taxed differently. In layman’s terms: S corps are taxed once, and C corps are taxed twice. But what exactly does this mean?

At the federal level, C corporations are first taxed on any and all profits. These federally taxed profits are reported on the corporation’s federal income tax return. Once these profits have been taxed, the after-tax profits can then be distributed to shareholders.

When C corp shareholders receive these profits in the form of dividends, they are then taxed again. Individual shareholders must report these profits on their individual tax returns, where taxes can be collected a second time.

S corporations are fundamentally different. From a tax perspective, an S corp is treated more like a sole proprietorship or a partnership than a corporation. Rather than being subject to corporate tax, any and all S corp profits are “passed through” the corporation and on to the individual shareholders. These profits are only subject to tax on the individual shareholders’ tax returns. This so-called “pass-through income” is a popular feature of the S corp form of incorporation.

What does this look like in practice? Consider this example.

Flexibility of Ownership

If the tax picture is seemingly so much better for an S corp, you may be wondering: why would anyone want to form a C corp? Actually, there are quite a few reasons that a C corp can make more sense for some businesses than an S corp.

For one thing, shareholder ownership is far more flexible. The IRS dictates that an S corporation is limited to no more than 100 individual corporate shareholders, and cannot issue more than one class of stock. Further, the shareholders of an S corporation must be U.S. citizens or residents. Additionally, an S corporation can’t be owned by another S corp, a C corp, an LLC, a partnership, or any kind of trust.

On the flip side, a C corp isn’t limited by any of these restrictions. This allows C corps to grow much larger (and faster) than S corps. A C corp can, for example, issue different kinds of stocks to different classes of investors, thus enabling the corporation to raise money from venture capitalists without offering them voting rights in the company.

Offering benefits

Depending on the size of your business, you may want to offer benefits to your employees. These can include health insurance, life insurance, disability, and other forms of fringe benefits.

As a C corporation, it’s possible to deduct the cost of the expenses associated with these benefits via the C corp’s federal income tax return. In other words, the cost of these benefits is not in any way taxable to the shareholders themselves (provided that these benefits are offered to a minimum of 70% of the corporation’s employees). With an S corporation, the cost of these benefits can’t be deducted, and the cost of the benefits is essentially taxable for any shareholder who owns more than a 2% share of the company — which, considering that the total number of shareholders is limited to 100, is generally a significant proportion of shareholders.

C corp or S corp: Which is the Right Choice?

Now that you have an understanding how C corps and S corps are both similar and different, you might still be asking yourself: which is right for myself or my client? Let’s take a moment to review some of the advantages of disadvantages of each.

C corp advantages and disadvantages:

S corp advantages and disadvantages:

For small businesses with limited plans for growth, an S corp can be an advantageous form of business organization. If you intend on significant and rapid growth, a C corp may be the better structure for your company. At the end of the day, it’s up to you or your client to make this decision.

S corps and C corps Under the New Tax Bill

Under the new tax reform law, many of the things tax regulations that relate to S corps and C corps are changing. The extent of these changes is still being discussed at the federal level. In order to offer knowledgeable and full spectrum services to clients, it’s essential for accountants and tax professionals to fully understand these changes. Basics & Beyond™ is offering comprehensive tax reform webinars to help prepare you for the upcoming tax season. To learn more about our offerings and register for a webinar, click here.