S Corp vs. C Corp: What Are the Differences and Benefits? Looking to learn more about S corporations and C corporations? Read more to find out which method is the most effective for your business.
By Dan Bova
If you are new to the business world, you may not be fully aware of what S corps and C corps are. You are not alone. Many are unfamiliar with these two basic types of corporations in America.
So why are these two corporation structures relatively unknown, and how are they important for you to understand as a business owner?
What is an S corp?
An S corporation is a business structure that alleviates companies of federal income taxes. This is done by "passing" the corporation's income, losses and credits to the shareholders, which is then reported on each S corp shareholder's tax returns. The "S" in the name stands for small.
What is a C corp?
A C corporation is separate from its owners, meaning it is considered its own legal entity. C corporations are taxed separately from their owners. This means the corporation must file its own tax returns and pay taxes on its profits.
C corps offer companies easier access to venture capital funding, making it an attractive corporate structure for startups.
Why are S corps and C corps important to know?
S corps and C corps are named for the sections of the Internal Revenue Code under which they get taxed (Subchapter S and Subchapter C, respectively). As these two differ in the form of tax returns, you must understand the legal and tax variations.
Because C corp taxes are levied at the corporate level, the profits distributed to shareholders are again taxed for each shareholder. This can affect both investors' and corporations' dividends that are paid out.
What are the similarities between S corps and C corps?
While significant differences make them attractive to certain companies and businesses, there are a lot of similarities between these two company infrastructures that are important to understand.
Corporate structure
A corporate structure is how a business is organized into different departments. As such, this structure can vary significantly between industries. However, there are several similarities when examining the structure of S corps and C corps.
Both of these corporations are obligated to certain corporate formalities. These might include regular board meetings, adopting bylaws, maintaining records certain records and filing articles of incorporation.
These corporations are both separate legal entities. They are distinct from their owners. This means the corporation, on its own, can enter into contracts, own assets and conduct business in its name, not the owner's
Another essential facet to note in both corporations is the board of directors. Both of these corporations have a board of directors that oversees management. The shareholders of a business almost always elect this board.
Related: The Basics of Business Structure
Legal compliance standards
While the formation process is different, both corporations must be formed according to the laws by which the state binds them.
In addition, both S corps and C corps must comply with regulations concerning shareholder rights, like the right to vote on corporate-level decisions or the right to receive dividends.
Both S corps and C corps are required to file annual reports with the state in which they are incorporated, as well as with the Internal Revenue Service (IRS) for tax purposes.
Related: Getting Paid on Venmo? This New IRS Rule Could Threaten Your Small Business.
Liability protection
Both S corps and C corps are designed with limited liability protection. This is made possible by the company promise: The investments in a company will never be surpassed by corporate expenses or losses. This protects the personal assets of shareholders in both of these structures.
Related: 5 Tips To Protect Your Company From Legal Liabilities
What are the differences between S corps and C corps?
These differences will affect your decision in choosing what kind of corporation you will form your business around, so make sure you properly understand the implications of each of these differences.
Formation process
To apply for one of these structures, you must be eligible. You must first be a registered C corp to achieve S corp status. So, the formation process is the same up to that point.
There are a couple of things a business must do to qualify as an S corp:
- You must be based in the US.
- Your company cannot apply if the business entity is a bank, insurance company or domestic international sales corporation.
- The shareholders allowed are either no partnerships, non-US citizens or other corporations.
- The shareholder limit is 100.
- The S corp in question may only have one type of stock. These cannot have preferred stock systems.
The C corporation is not bound by any more specific rules that S corps require to take advantage of its benefits.
Ownership structure
As mentioned above, only a few types of ownership are allowed in S corps. In addition to that and the 100-shareholder limit, S corps have restrictions on who can own shares in the company.
S corporations cannot have more than 25% of their ownership held by non-resident aliens, and other corporations or partnerships cannot own them. C corporations do not have these ownership restrictions.
Stocks and shares functionality
While C corporations are allowed to issue common and preferred stock, S corporations can only issue one class of stock. This restriction enables equal voting rights within the corporation and the right to equal dividends from the company.
Related: What Is Equity and How Do You Calculate It for Shareholders? Here's What You Need to Know.
Taxation expectations
The most notable difference between C corp and S corp types of businesses is their tax status. C corporations are subject to double taxation, which means that profits are subject to corporate income taxes and then again at the personal income tax rate when they are distributed to shareholders as dividends.
C corp shareholders, unlike S corps, cannot write off business losses to offset other income on personal income statements.
S corporations, on the other hand, are not subject to corporate-level business taxes. Instead, the profits and losses of an S corporation are passed through to the shareholders, who report them on their personal tax returns.
What are the benefits of being an S corp?
1. Pass-through tax benefits
S corporations don't pay federal taxes on their respective corporate level. Instead, they file taxes like a sole proprietorship or partnership. The shareholder's dividends are taxed as business income. The shareholder receives the income, deductions and credit through a process known as "passing through."
Unlike C corporations, which face double taxation at the corporate and personal asset levels, S corporations avoid this by "passing" these attributes to the shareholder.
Not only does this pass-through taxation allow for potential tax savings for the shareholder, but provides greater flexibility for the management of taxes of corporate operations.
2. No accumulated earnings tax
A pass-through entity accounts for no tax attributes. Each of these flows to the individual shareholders and is reported on their tax returns.
The shareholders then pay taxes on their share of the corporation's income or deduct their share of the business's losses on their corporate tax returns.
3. Easy to transfer ownership
Because of the limited size of S corps, transferring ownership can be much simpler than in a large company. This small number allows for easy negotiation and transaction of selling ownership.
And if you ever do sell your ownership, the tax payments for an S corp sale are substantially lower. This is yet another benefit for the S corp title.
What are the benefits of being a C corp?
The S corp offers significant benefits; however, it has drawbacks. So how does the C corp match up against these benefits and address the problems S corps fail to solve?
1. Unlimited shareholders
Because of S corps' limited size, growth in the company can be difficult. With the unlimited number of shareholders, this provides more flexibility for the company, as well as growth potential.
C corporations can also distribute shares of stock to any entity, including individuals, other corporations, nonprofits, partnerships and non-U.S. residents. This can make it easier for a C corporation to attract investors from various sources.
With this unlimited number, C corporations do not have any restrictions on how income and losses are allocated among shareholders.
Unlike S corporations, which allocate profits and losses in proportion to each shareholder's ownership percentage, C corporations can choose distributions of income and losses in any way they see fit, which can provide greater flexibility in structuring ownership and investment in the company.
2. More attractive to investors and VCs
C corporations are more attractive to investors and venture capitalists (VCs) for several reasons. This funding mechanism can be vital for success when starting a new business or startup.
Because C corporations perpetually exist, this is an attractive, stable investment. The company's well-being does not rest on one person staying or leaving the company. This is attractive because it provides excellent stability for investors looking for long-term gains with low risk.
Unlike S corporations, which are restricted from receiving public offerings, C corporations can raise capital through issuing multiple classes of stock (for instance, preferred or common stock), once again taking advantage of the unlimited number of investors.
While this can be costly, this provides investors and VCs with an opportunity to invest in more extensive and significant activities. It's important to remember as an investor that public offerings are typically reserved for larger, more established companies with substantial growth potential.
Related: 10 Ways to Make Your Company More Attractive to Investors
3. Ability to deduct net operating losses
C corporations, while having double taxation, have tax advantages like deducting expenses and losses. These can attract investors and VCs looking to multiply their benefits and gains in company investments.
This deduction occurs through the net operating loss (NOL) deduction. If a C corporation incurs operating losses, it can use this loss to its advantage at taxable income for future tax years.
This means that if the corporation has a profitable year in the future, it can use the NOL deduction to reduce its taxable income and lower its tax liability.
Again, keep in mind the limitations and rules of any business tool. Understand the concept and continue research to familiarize yourself with NOL and other ways to take advantage of tax benefits.
Related: Top 5 End-of-Year Tax Strategies for Small Businesses
How do you know whether an S or C corp suits you?
So how do you determine which is right for you? What does your company need to get to the next level of business in its field? Maybe double taxation isn't an issue for your circumstance because of the massive scale of your company. Perhaps the C corp is right for you.
However, tax benefits might be what you need. Just make sure you abide by the strict rules in place for an S corp and are ready to face the hardships of restrictions that come with the S corp status.
While the S corp title has both pros and cons, you should always consider yourself and your business first. Is the S corp title worth the rigid filing and pressure of IRS restrictions? Or is having a C corp for your smaller business worth the heavier doubled taxation?
The structures addressed in this article have a lot of similarities and critical differences. But these are just two of many.
The Limited Liability Company (LLC) and Limited Liability Partnership (LLP) structures haven't been mentioned. Keep this in mind during your journey in selecting a suitable business structure.
Related: The 5 Biggest Tax Differences Between an LLC and Corporation
Remember that the IRS has many operation rules and regulations specific to an S corp. Any variation or failure to meet such standards can result in losing the hard-earned S corp status.
And as always, understand your options and what they entail. You can consult a professional tax advisor or business consultant for more details that apply directly to your business.
Check out Entrepreneur's other articles for more information about corporations and other financial topics.
