When it comes to starting a business with a potential for growth, a corporation is hands down the best business structure to make your business activity legitimate and smoothly run it further on. But once you decide to incorporate, most likely than not, you’ll face a dilemma of which type of corporation to choose for your business. Basically, there are two types of corporate entities including a C-Corporation and an S-Corporation. At a glance, they seem to have quite a similar structure but in practice, they are not the same at all. In our S-Corporation vs C-Corporation guide, we’ll review each type in detail and describe how they compare to each other. We will help you find out the difference between S-Corp and C-Corp to decide which of these two types is right for your business.
What Is a C-Corporation?
In fact, a C-Corporation is what we normally consider a corporation. It’s a legal business structure created by multiple shareholders but separate from its owners in terms of legal rights. In other words, like a person, a corporation is entitled to make decisions, own and handle assets and property as well as it is liable for its own expenses and separately sued for any violations. It is worth noting that payable taxes are also separate, i.e. a C-Corp pays its own taxes while shareholders pay theirs. In this context, it allows to effectively segregate personal and business expenses but results in double taxation for the business owner.
C-Corp subtypes are public and private corporations. While public corporations trade on the stock market, private ones are closed entities owned by a limited number of shareholders.
To set up a C-Corporation, you just need to register it in the state where it operates and it will take only a few easy steps.
What Is an S-Corporation?
Right off the bat, an S-Corp doesn’t stand for a “smaller corporation”. The name is related to the S Subchapter of the Internal Revenue Code. This structure removes the burden of double taxation from business owners by introducing a so-called pass-through taxation system. To clarify, each stakeholder pays taxes to the state pro rata with the income they share in the company revenue. A little catch here is that corporate losses, damages, and credits will also pass through company owners. Besides, shareholders are not exempted from paying taxes even if the corporation pays no dividends to them.
As a structure, an S-Corporation has a number of subtypes including a sole proprietorship, limited liability company, limited liability partnership, and master limited partnership.
From the legal point of view, you can’t form an S-Corp from the start. You need to set up a C-Corporation first and then apply for an S-Corp status with the Internal Revenue Service or IRS. More than that, there are certain requirements to forming an S-Corporation that we’ll describe below.
C-Corporation vs S-Corporation: Benefits and Drawbacks of Each Corporate Status
Each type of corporation has something to offer to a certain business format. At the same time, each corporate status is not an impeccable business model. Both C-Corps and S-Corps have their pros and cons and you need to be aware of them to make a well-informed decision on which corporation will work for you.
- No restrictions on the number of shareholders and their ownership. A C-Corp can be formed by any number of shareholders, be it a physical person or a business entity, or even a non-US resident. And each of these shareholders can own a share in the company equity proportional to their investment in the capital.
- No limitations on stock classes. Corporations are eligible to issue shares and C-Corps really excel in this concern since they are not exposed to any restrictions on the class of stock they issue and can have different stock classes.
- Lower tax rates as compared to other business structures. Corporations pay taxes under special rates that are overall lower than those established for individuals and sole proprietorships. Recently, the Tax Cuts and Jobs Act has reduced the corporate tax rate to 21% that stands strong against individual rates hitting far above 30%.
- More opportunities for raising added capital. Corporations can easily raise financing for business development or working capital via investments and a Subchapter C of the Income Revenue Code that regulates C-Corporations is not restrictive in this concern.
- Double taxation is the biggest C-Corp disadvantage. While the company is liable for the tax on its earnings, shareholders have to pay taxes on their dividends. Thus, in reality, owners pay taxes twice.
- Higher formation and running costs. In contrast to partnerships and sole proprietorships, corporations are quite expensive both to start and to run. Though expenses vary by state, on average, those costs stand on the higher end and amount to thousands of dollars.
- Higher tax burden overall. Being an individual businessman, you‘ll have a number of credits on your personal tax return. Meanwhile, shareholders can’t write off any losses on their tax return and have to move them forward to the next financial year.
- No double taxation. With an S-Corporation, taxes are paid only at the personal level and the company is not exposed to corporate taxation. Shareholders pay taxes on the income they gain by receiving dividends or a part of company profit proportional to their equity share.
- Personal income tax reduction. It’s a big plus for business owners who can classify their corporate income as salary, thus, cutting down self-employment taxes.
- Deductions. S-Corp status offers a number of tax deductions on employee-related company expenses. Overall, shareholders can deduct up to 20% of net company income on their personal return.
- Writing off company losses. Though in S-Corp, shareholders are responsible for the company’s profits and losses alike, the good thing is that business owners can write off losses on their individual tax return, which is a real advantage for a new business not earning much profit from the start.
- A limited number of shareholders. The company should have 100 or fewer shareholders which means it can’t become a public corporation and limits its ability to raise capital.
- Ownership restrictions. Shareholders are to be individuals and US residents which makes some types of equity financing ineligible for S-Corps.
- No stock flexibility. To file for S-Corp status, the company should have only one class of stock.
- Strict compliance rules. S-Corps are closely controlled by the IRS. The authority can terminate the S-Corp status if the company violates certain compliance rules. For the shareholders, it results in restriction of their rights to transfer or sell their equity share.
What Are the Similarities Between S-Corp vs C-Corp?
Irrespective of their IRS status, all corporations share some common characteristics that set them apart from other business entities and will help you understand why a corporation is a better structure for your business than an LLC or a sole proprietorship, for example.
- Secure limited liability: In the eyes of the law, both corporations are separate legal entities independent from their owners when it comes to company liabilities. To put it simply, shareholders are not personally responsible for the company obligations.
- Incorporation process: All corporations start in the same way. You need to file the Articles of Association along with a number of incorporation documents to the Secretary of State, appoint a registered agent, and make up internal bylaws.
- Company Structure: S-Corp and C-Corp are both shareholder companies controlled by the Board of Directors and operated by managing officers or company directors. While business owners appoint the Board members, the Board elects the operating officers.
- Compliance aspects: No matter the type, corporations are the only entities eligible to issue stock. In the meantime, to operate legally and meet all state requirements, corporations have some routine formalities to follow such as holding regular board meetings, operating meetings, and shareholder meetings as well as maintaining appropriate internal documentation.
What Are the Differences Between C-Corp vs S-Corp?
The major obvious difference between these two corporation types is in the taxation approach. While C-Corps pay corporate taxes, S-Corps use a pass-through taxation system that transfers business profits and losses to personal tax returns of the company owners, thus avoiding a corporate tax. However, there are a lot more other aspects where C and S-corporations are different. To make it easier for you to grasp all the details, we’ve summed those differences into three categories including formation process, taxation, and ownership.
This is where you come across a basic difference between an S-Corp and C-Corp. Choosing to register your business as a corporation and sending your Articles of Incorporation to the Secretary of State, your company will be established as a C-Corporation. So, a C-corp is a default corporation type you can’t actually skip.
How to form an S-Corp then? Forming an S-Corporation just needs some more paperwork to be done. To obtain Subchapter S status for federal taxes, you must apply Form 2553 to the Internal Revenue Service. On top of that, there might be some other documents you’ll have to provide on the state level to legalize your S-Corp status.
Basically, S-Corp and C-Сorp are two different tax designations or two ways how your business can be taxed if you choose to incorporate.
As we’ve mentioned above, C-Corporations experience both corporate and personal taxes and bear the burden of double taxation. To avoid taxes, either the company should operate at a loss or owners should reinvest business profit instead of distributing dividends. And while it’s a quite common business scenario for smaller starter projects, this method is not viable for growing companies that stand strong on their feet. To make it easier for C-Corps, the Tax Cuts and Jobs Act has introduced some changes to corporate taxation and levelled the business tax rate for C-Corps at 21%, whatever their income. Yet, it still doesn’t eliminate double taxation.
Once you want to distribute the company income and receive dividends, you’ll think about getting an S-Corporation status. By filing IRS Form 2553, you can create a pass-through business entity exempted from corporate tax payments. For tax purposes, company profits and losses pass to the shareholders’ personal tax returns pro rata with the equity shares. And they will pay income taxes on their personal tax rates. No double taxation here. Besides, S-Corporations are eligible to make use of deduction ensured by the law. Thus, business owners can deduct 20% of qualified company income from their personal taxable income.
Despite the fact that both corporations have shared ownership by issuing shares and distributing them among multiple owners, they do differ in the number of shareholders and their nature as well as in the class of stock companies can issue.
Distinguished by an obvious tax advantage, S-Corporations have a drawback when it comes to ownership. Not only the shareholder number is limited by 100 members but also those members are to be individuals and US citizens or residents. As such, this restriction limits external investment opportunities over time.
A C-Corp, on the other hand, allows for any number of shareholders including both physical persons and legal entities. It means, the company can issue shares to engage new investors and raise additional financing to maintain business growth.
Speaking of stock classes, an S-Corp is entitled to issue only one type of stock while a C-Corp can issue different share classes providing different voting rights and benefits to shareholders.
Which Type Is Right for My Business?
To wrap it up, similar in many basic aspects and different in some key ones, C-Corporation and S-Corporation are good for different business purposes. To choose one type, you need to answer the question of whether you seek to save on taxes or target business growth. While S-Corporations minimize the tax burden, especially valuable for new smaller companies operating at a loss during initial years, a C-Corp status gives more flexibility and freedom in raising capital to finance business growth. Yet, higher investment potential comes at a cost of double taxation