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:
- Separate legal entities. Both S corps and C corps are distinct from other forms of doing business (such as a sole proprietorship) in that they involve the creation of a separate legal entity. This separate legal entity is created at the state level, and registered with the Secretary of State.
- Protecting personal assets from business-related liability. Regardless of whether you choose an S corp or C corp, both of these forms of incorporation are distinct from something like a sole proprietorship. How? They allow for the protection of personal assets in the event of a business-related liability. If you’re the owner of a sole proprietorship, your business is intermingled with you as a person. If someone takes issue with your business and decides to pursue legal damages of some kind, you will be personally responsible for them. With an S corp or a C corp, however, you’re more protected. Someone can sue your corporation for damages, rather than you as an individual. This is a important thing to take into consideration, especially in certain industries that present a higher risk of potential liability.
- Personal and business finances must be separate. In keeping with the above point, your personal and business finances must be kept separate from one another. This is of course always encouraged, but it’s much more essential in the case of an S corp or C corp than it is with, say, a sole proprietorship.
- Issuing of stock and legal structure. All corporations must issue stock to their shareholders. The shareholders are the owners of the corporation. They elect the directors of the corporation (from among the shareholders), and the directors then hire officers to manage the day-to-day affairs of the corporation. These are the titles you’re likely already familiar with: Chief Executive Officer (CEO), Chief Technical Officer (CTO), and so on.
- Internal corporate formalities. Whether you opt to form a C corp or an S corp, you’ll be expected to follow the same set of internal legal formalities. This includes things like adopting company bylaws, filing the required annual reports, paying annual fees, issuing stock, holding shareholder meetings, and organizing and conducting director meetings.
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:
- Completed and filed anytime before the 16th day of the 3rd month of the current tax year (which means March 16th for calendar year tax filers); or
- Any time during the prior tax year. That said, any election made no later than 2 months and 15 days after the beginning of a tax year in which the tax year is less than 2.5 months long is considered to be “timely” for that tax year.
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.
- C corp taxation: Imagine that a business is registered as a C corp. Under the new 2018 tax reform bill, the corporate tax rate is now fixed at 21%. If a corporation earns $100,000 in profit, it will first be taxed at 21%, resulting in $79,000 after federal taxes. This amount could then be distributed to shareholders. If it’s distributed entirely to a single shareholder and taxed at a rate of 22%, that taxpayer would owe $17,380 in taxes. Their net total payout would be $61,620.
- S corp taxation: Now, consider what this would look like for an S corp. Imagine that a full $100,000 in corporate profits are passed through the S corp an on to a single shareholder. That shareholder is then taxed on their personal income taxes at a rate of 24%. This equates to $24,000 in federal income taxes, resulting in a new payout of $76,000 as opposed to the $61,620 cited above. That’s a difference of $14,380.
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.
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:
- Limited liability allows you to protect yourself from individual liability in the event of a lawsuit.
- C corps exist in perpetuity: even if the originator of the corporation were to pass away, the business would continue to exist.
- There is no limit to the number of shareholders that can own stock in a C corporation.
- Raising money for a C corp tends to be easier than attempting to raise funds for an S corp. There are multiple reasons for this. For one thing, the fact that C corps can issue different kinds of stock means that they can raise money from shareholders without those shareholders having decision making power in the company. Investors are not responsible for errors that the corporation makes, meaning they’re not legally exposed when investing. C corporations can also be owned by other corporations, which means that there’s a possibility to sell the business to another company down the road.
- The cost of fringe benefits can be deducted from tax liability.
- C corporations are taxed twice: once for the corporation, and again for each shareholder’s distributions.
- Corporate structure and filings can be complicated, time consuming, and expensive.
S corp advantages and disadvantages:
- Like C corps, S corps allow for limitation of liability in the event of a lawsuit.
- Also in keeping with C corps, S corps exist perpetually.
- Pass-through taxation means that S corp income is only taxed once. This can amount to a significant amount of tax savings for certain individuals, particularly for small business owners.
- For the owner of an S corp, any business losses can be written off on their individual income tax return. If you’re just starting up your business and are expecting to claim a loss your first few years, this can help to counterbalance other sources of income on your personal return.
- S corps can issue stock to help grow the business. However, the number of shareholders is limited to 100, and these shareholders must be residents of the United States. For a company that wants to grow quickly and attract international investors, this can be problematic.
- Filing requirements for S corps are stringent. If you omit a document or commit some sort of error, the IRS can cancel your S corp status — at which point you’ll have to file taxes as a C corporation.
- Like C corps, S corps have to deal with a significant amount of filing paperwork. This results in added expense and time for a small business.
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.