Taxes

Understanding C Corporations vs. S Corporations

Jul 01, 2021 • 10+ min read
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      Corporations come in all shapes and sizes: there are massive companies like Apple and Nike but also single-person corporations or those with only a handful of employees.

      A corporation, for tax purposes, doesn’t have limits on its size. If you are a small business owner, you may want to consider establishing yourself as a corporation. In the eyes of the IRS, you can either become a C corporation or an S corporation. Understanding the difference between these 2 concepts can help you file for the correct status—and file your taxes more easily. 

      Learn about the differences between C-corp and S-corp business designations to decide which type of business is best for you.

      S-Corps Use Pass-Through Taxation

      One of the biggest differences between S corporations and C corporations is that S-corps utilize pass-through taxation. Essentially, the business itself doesn’t actually pay taxes, which means the tax burden passes through to its owners. 

      Pass-through taxation is often used for small business owners, partners, and sole proprietors. For example, a freelance web designer might establish an LLC to protect their personal finances. Even though their clients pay the LLC, all profits go to the individual who owns it. The LLC doesn’t have any profits to report, which means it can’t pay taxes. Even if the company reported profits, the business owner would have to pay taxes twice (once as a business entity and once as an individual). 

      With a pass-through entity like an S-corp, all of the company profits are credited to the shareholders. This is the taxable income, not the revenue from the business. The shareholders and owners will report the earnings on their personal income tax forms and pay the IRS in this manner. 

      With a C-corp, the corporation is taxed, which means the owners pay taxes twice. First, the company pays corporate income tax, and then the shareholders pay personal income tax. There is also a greater risk of double taxation when corporate profits are paid to shareholders as dividends. The IRS has guides for both S-corps and C-corps to fill out the proper tax forms and report their income rates each year.  

      While setting up pass-through taxation might seem like a strategic move for your business, there are benefits to creating a C-corp instead of an S-corp. Whether you will reap these benefits depends on the future growth plans and structure of your organization.

      S-Corps Have Limited Shareholders

      Startup founders who want to bring in several stakeholders and eventually become a publicly-traded company often prefer C-corps. You aren’t limited by the number or types of shareholders you can have with a C-corp. 

      With an S-corp, however, the number of shareholders you can have is limited. No S-corp can have more than 100 shareholders, and they must all be US citizens. Additionally, you can only have 1 class of stock for your shareholders. While different shareholders can hold different percentages of the company, they each have the same type of stock.

      For example, Google has 3 different classes of stock. Each class is meant to provide different benefits to shareholders and powers to the founders:

      • Class A: This is the standard option, where 1 share means 1 vote. If you invest in Google today, then you will most likely be a Class A shareholder. 
      • Class B: This stock is primarily held by the founders who want to maintain control of the company even when people keep buying it. With this option, each share grants the holder 10 votes.
      • Class C: This stock is mostly held by employees. This class has no voting rights.

      This structure gives the most voting rights to the founders. Similar structures at other companies deny voting rights to some classes of shareholders. If you plan for your business to go public or if you want to open your company to new shareholders, you may need to create different share classes. 

      C-corps are better able to raise venture capital because of their share structures. It may be harder to lure investors to your business if you choose to open an S-corp—important if you don’t plan to bring your business public but want to grow your working capital through private investment in the future. 

      However, this is a non-issue if you only have a few key owners. Many S-corps are run by sole proprietors who are their only owners. They own 100% of the shares and take home 100% of the dividends. If you only plan to bring on a few investors, you might not need to consider the complexity of a C-corp. 

      In the case of both S-corps and C-corps, you will need to report all of your shareholders in your tax documents. The S-corp application allows owners to add additional pages if there are more than 10 shareholders when the business is established. This proves that all of the shareholders approve of the formation of an S-corp and the tax burdens that come with it. 

      C-Corp Is the Default Formation Option

      When you decide to form a corporation, C corporation is the default option. It is possible to register with your state or file articles of incorporation today as a C corporation. However, if you want to become an S corporation, you will need to take steps to apply for this status through the IRS. 

      Companies that want to reach S-corp status need to complete IRS Form 2553. With this form, you’ll need to explain when your fiscal year starts and ends (if different from December 31), and this date will determine your deadline to file.

      Companies that start their fiscal year on January 1 need to file Form 2553 by March 15 to qualify for the current tax year. If your fiscal year starts earlier or later, then the IRS sets different time deadlines. If you fail to complete Form 2553 by the deadline, then you might not qualify as an S-corp for another year. 

      The IRS will let you know if your business qualifies to operate as an S-corp. The application process typically takes a few weeks—longer if Form 2553 is filled out incorrectly or if the IRS is experiencing backlogs in its mail. 

      Regardless of whether your company gains approval to become an S-corp, you’ll still need to follow the same steps to form your business, submit an annual report to your state, and pay incorporation fees. You’ll also need to appoint a registered agent to act on your company’s behalf and create bylaws and guidelines for shareholders. Each year, if the number of shareholders or the percent each owner has under their name changes, you’ll need to report the adjusted ownership to the IRS.

      It Is Harder to Transfer Stock With an S-Corp

      With standard corporations and publicly-traded firms, the market determines the value of each share. This is why a shareholder can buy the stock at different prices—they might buy at 1 level and then increase their shares when the price drops in the future. However, with an S-corp, there is no public listing to determine a share price. There also aren’t easy ways for shareholders to sell their stock and buy from other companies. 

      With an S-corp, an existing shareholder will need to work with the owner and other shareholders to sell their holdings. They’ll also need to agree on a market price for the buyout, typically based on the initial investment and changes to the company since then.

      For example, if an initial shareholder invested $10,000 and the company has grown significantly in the past few years, they might sell their shares for $20,000 because of the increase in the company’s perceived value. If the owner wants to buy out a shareholder, they will make a compelling offer for the shares in order to entice them to sell.  

      With IRS Form 2553, the owner needs to list each shareholder and their percent ownership. If a company has an ineligible shareholder—like someone outside of the United States or over the 100 person limit—then the S-corp status may be disqualified. While you can bring on new shareholders and buy out other shareholders as an S-corp operator, think about the challenges of transferring stock and how it could affect your business. 

      Your Corporation Status Can Help or Hurt Your Taxes

      While the main difference between S-corps and C-corps is how they are taxed, it’s also important to look at the rate at which corporations are taxed. For example, according to the 2017 Tax Cuts and Jobs Act, individual taxable income can range as high as 37%. However, C-corps are taxed at a flat 21%. This means that the taxes that business owners pay as a C-corp might be lower—even if they have to pay both corporate and personal taxes. 

      However, according to the same act, owners of pass-through entities (like S-corps) may be able to deduct up to 20% of their business income from their tax returns. This provides a significant tax deduction if you are paying a high rate of personal income tax. 

      While these 2 tax rate benefits are significant, it’s hard to determine which option is better. If you want to look at different scenarios based on your current financial situation, a tax specialist or accountant should be able to help you work out the numbers and find ways to help you save money. 

      Consider Whether You Are Distributing or Reinvesting

      While your shareholders can help to determine whether an S-corp or C-corp is better for your business, you also need to consider what you plan to do with your profits. 

      If the majority of your profits will get distributed to your shareholders, you may be better off operating as an S-corp. This way, you won’t pay taxes on your profits as corporate income and then pay taxes on personal dividends. 

      However, if you plan to reinvest the majority of your profits within the organization, your business may be better off as a C-corp. For example, as an owner or manager, you would pay taxes on the salary you get from the company and submit a standard W-2 form with your personal income taxes. You can then spend your company profits on additional investments—like paying down the mortgage on your office space or investing in additional fleet vehicles to grow your team. In this case, the profits become line items on your balance sheets as tangible assets. 

      If you have strong plans for growth in the future, then a C-corp may be a better option. You will turn most of your liquid capital into assets instead of paying out cash to shareholders.    

      Both S-Corps and C-Corps Provide Personal Protection

      One of the main benefits of both S-corps and C-corps: they protect the income and assets of the individual owners and investors. This is why you see sole proprietors and partnerships become corporations—particularly limited liability corporations (LLCs). 

      If you operate as an individual owner without protection, your clients or employees can pursue your personal assets if they feel you have wronged them. For example, if you fail to complete a project for a client and they win a lawsuit against you, then the creditors claiming the damages may be able to go after your personal assets, like your house or savings accounts. If you can’t pay the damages in cash, these creditors might be able to claim your car as an asset. 

      However, with a corporation, the creditors can only claim funds from the company, not the individual. If you have a company car under the business’s name, then the creditors can use that. However, they can’t touch any of your private assets. In the case of sole proprietors who form S-corps, most of the income passes through to the individual. This makes the business almost worthless except for any reported assets, equipment, or funds that haven’t been paid out. 

      Even if you aren’t sure whether you want to form an S-corp or C-corp, take steps to become a corporation to protect yourself as your business grows.    

      Management Still Operates the Business

      Another similarity between S-corps and C-corps is that management still operates the business, even if there are multiple shareholders. For example, a startup founder might own 60% of the business and have 4 shareholders who each own 10%. If the founder is managing the day-to-day operations of the company, they’ll continue to run the business regardless of who the shareholders are. 

      Corporations aren’t run by shareholders. Just because you buy stock in Apple doesn’t mean you work there. Most corporations still have a C-suite (CEO, CFO, etc.) and senior leadership levels that are responsible for managing the business. 

      However, the owner and executive board of directors need to act in the best interest of the shareholders. This is called the “fiduciary duty of loyalty,” and it states that any executives must act in the best interest of the business or shareholders. This prevents owners from making decisions that they would directly profit from but could hurt shareholders and negatively impact employees.

      This fiduciary duty is often why employees have different shareholder classes where they cannot vote on issues related to the company. They might know more about the operations than other voters—potentially leading to insider trading—or they could impact the company’s performance in order to profit personally.  

      As you file to become a corporation, don’t get confused by what it means to be a shareholder or investor. If any confusion arises, create written guidelines in your bylaws about the rights of shareholders and the ethical responsibilities of owners. Ask a lawyer to review them and have your shareholders sign them before becoming cleared to buy into your firm. 

      Evaluate Your Current and Future Business Goals

      If you want to grow your shareholders and improve your working capital by working with investors, you may want to establish your business as a C-corp. If you plan to grow your business and keep your capital tied up in assets, you may benefit from working as a C-corp.

      However, if you want to continue operating as a pass-through entity and expect to have a limited number of investors, an S-corp might be a better option. Review your choices and your plans for your future before you begin the S-corp application process. 

      If you ever need to change your status with the IRS, you will need to fill out extra paperwork and navigate a waiting period. While it’s possible to change your status, you will have fewer headaches if you move forward with the right business structure on your first application. 

      About the author
      Derek Miller

      Derek Miller is the CMO of Smack Apparel, the content guru at Great.com, the co-founder of Lofty Llama, and a marketing consultant for small businesses. He specializes in entrepreneurship, small business, and digital marketing, and his work has been featured in sites like Entrepreneur, GoDaddy, Score.org, and StartupCamp.

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