What are C Corps & S Corps?
Before getting into the definitions, differences, and similarities of C Corporations and S Corporations, let’s talk about what makes a corporation.
When forming a business, it can be a sole proprietorship, limited liability company (LLC), or corporation. When you form a corporation, you file articles of incorporation, and C Corporations are the default status. You can file Form 2553 to change your tax status to an S Corp.
Both C Corporations and S Corporations take their names from their respective IRS internal revenue code subchapters. C Corps are in subchapter C, while S Corps are in subchapter S.
Choosing which type of corporation depends on your company’s ownership structure and business goals. Let’s look at the differences between the two types of corporations.
C Corp vs. S Corp: What are the differences?
There are several key differences between C corporations and S Corporations.
Corporate Tax & Personal Income Tax
The most significant difference between the two is how they are taxed. C Corporations experience what’s called “double taxation.” They must pay corporate income tax on revenue, and then shareholders pay additional tax on any dividends they receive.
S corporations only pay tax once, with what’s known as “pass-through taxation.” Instead of paying corporate tax, any shareholder earnings are filed with their personal tax returns. Federal income tax rules still apply to personal income tax returns for S Corporation shareholders.
In addition, S Corporation shareholders can deduct up to 20% of business tax. S corporation shareholders can also deduct business losses if they meet certain criteria.
The most significant advantage of an S Corporation is avoiding double taxation. While the “S” in S Corp comes from Subchapter S, a handy pneumonic to remember is “S Corp = Special taxation.” S Corps are also Small Business Corporations.
Ownership
S Corporations come with significant restrictions on ownership. S Corps are limited to 100 shareholders, who must be individuals and US citizens. This means S Corps cannot go public and must be a privately held company. It also creates roadblocks when shareholders want to sell their shares and get out of the corporation.
C Corporations don’t carry any restrictions on ownership. A C Corporation can have unlimited owners, such as other corporations, holding companies, or trusts. In addition, shareholders are not limited to the US. Both the corporation and shareholders can be based anywhere in the world.
Stock
S Corporations are limited to one class of common stock (disregarding voting rights). C Corporations can have multiple types of stock, giving them more options when selling shares. Many investors like preferred stock options.
Formation
You actually don’t form a C Corporation or an S Corporation – you create a corporation. C Corp and S Corp are different tax statuses, and your company can choose to elect or not elect S Corp status. Knowing what tax status is most beneficial for your business ahead of time is helpful.
All corporations receive a default C Corp taxation status. If you want to change your business’s tax status to S Corp for the pass-through taxation benefit, you must file Form 2558 with the IRS. Depending on your state, you might have to file additional paperwork.
What are the similarities between C Corps and S Corps?
Since C Corps and S Corps are both corporations, they share many of the same structural and operating components.
Incorporation
C Corps and S Corps start the same way – by filing articles of incorporation with the state. First, you must select a business name. Then you file with the secretary of state – expect some filing fees. Once incorporated, you receive a business tax identification number and need to create a business checking account.
Usually, during the incorporation process, you will also decide whether to accept the default C Corporation status or elect S Corporation status. If you go with S Corp, you most likely need to file additional paperwork with the state. In addition, you need to name a registered agent for the business. The registered agent accepts legal and tax documents on behalf of the company.
Structure
After being incorporated, both types of companies conduct a shareholder meeting to establish an operating agreement. The operating agreement outlines the company’s bylaws at the shareholder level. The agreement should establish ownership stakes, set limits on the number of shareholders, and create rules for financial distributions.
Corporate Formalities
The shareholders of either a C Corp or an S Corp then select a board of directors. The board sets policy and management decisions. The first major decision for the board of directors is selecting the CEO, which in turn chooses the management team to run the business’s day-to-day operations. The board of directors meets quarterly to discuss the business and make managerial changes. The quarterly meeting minutes are made available to all shareholders.
Limited Liability Protection
Limited liability means shareholders are only responsible for what they invested in the company. Shareholders’ personal assets are protected as they are not responsible for the company’s business debts or financial obligations. If anything happens to the company, you won’t have to pay for financial responsibilities out of your pocket.
Separate Legal Entities
Both C Corps and S Corps can do business as (DBA) as separate entities. Conducting business through a separate entity is a sort of corporate shield or veil of protection to further protect shareholders from liability.
Frequently Asked Questions
Here are the most common questions on C Corp v S Corp.
What are the advantages & disadvantages of C Corps?
C Corporations carry various advantages and disadvantages. You should weigh them carefully before deciding on your corporation’s tax structure.
C Corporation Advantages
One of the most significant advantages of a C corporation is the ownership structure. There are no limits on the number of owners or shares to a C corp, which makes bringing investors on board much easier. Not to mention if you ever go public with an initial purchase offer (IPO), being set up as a C corp makes that much easier. Almost all publicly traded companies are C corps.
There is also no limit to the type of investors in a C Corp. Other corporations, trusts, or other organizations can be C Corp shareholders. They also don’t have to be based in the US.
C Corporations are easier to form. Since C Corps are the default, there is less paperwork.
C Corporation Disadvantages
Double taxation is the most significant disadvantage of a C Corp. Not only does the company have to pay corporate tax, but shareholders must then pay tax again on dividends. C Corp shareholders can’t write off business losses, either. Double taxation can be the difference between being profitable and losing money for smaller and medium size companies with lean revenue streams.
There is some relief for corporate tax, though. Under the 2017 Tax Cuts and Jobs Act, corporate tax is capped at 21%, and the same Act established a maximum personal tax rate of 37%.
Another advantage of C Corps compared to S Corps is that they face less IRS scrutiny. Since S Corps have a special tax status, the IRS follows them more closely. With a C Corp, you don’t have to worry about the IRS as much as you would with an S Corporation.
C Corp Pros & Cons
Pros:
- It’s easier to form a C Corp.
- It’s the default tax status for corporations.
- There’s no limit on shareholders.
- Easier to get equity funding.
- Easier to go public with an IPO.
- Less IRS scrutiny.
- Limited liability protection.
- Able to do business as a separate legal entity.
Cons:
- Double taxation at the corporate and shareholder level.
- More rigid structure than non-corporation businesses.
- No write-offs on personal income tax for business losses.
What are the advantages & disadvantages of S Corps?
An S Corporation tax status is ideal for small businesses that don’t intend to go public. Let’s look at the advantages and disadvantages of S Corporations.
S Corp Advantages
The most important advantage is that S Corps are pass-through entities. The profits and losses of an S Corp pass through to the shareholders. S Corps don’t pay federal corporate tax. Instead, the IRS taxes qualified business income on the personal income tax returns of the shareholders.
In some cases, corporate losses can also pass through to shareholders. There are limitations on shareholder losses, though.
In addition to the advantages of pass-through entities, S Corporations get many of the same benefits of being a corporation. S Corps get limited liability protection and can do business as separate legal entities, and they have independent life from the shareholders. If a shareholder departs, the company can continue like a C Corporation.
S Corp Disadvantages
Since the primary advantage of S Corp status is avoiding double taxation, let’s start with the disadvantageous flip side: increased IRS scrutiny. The internal revenue service monitors S Corps more closely than other corporations. One slip up on the S Corp limitations, and you lose your S Corp status.
S Corps are limited to 100 shareholders, who must be individual US citizens. Other corporations and partnerships cannot hold S Corp stock, although some trusts and tax-exempt organizations are exempt from the rule.
There are also limitations on the class of stock. S Corps can only have a common stock class.
The limitations on shareholders and stock class make it more challenging to receive equity funding. You can only have so many investors whose stock options are limited to common stock.
S Corporations Pros & Cons
Pros:
- Avoids double taxation.
- Able to write off business losses in some cases.
- Limited liability protection.
- Able to do business as a separate legal entity.
- Ideal for small businesses
Cons:
- It can’t become a publicly traded company.
- Limited to 100 shareholders.
- Strict shareholder requirements.
- Can only have one class of stock.
- Increased IRS scrutiny.
- More rigid structure than non-corporation businesses.
C Corp vs. S Corp: What’s right for my business?
Deciding between C Corp and S Corp tax status comes down to your unique needs and goals. Before you even decide on which corporation tax status, you should determine whether a corporation is a proper structure.
Let’s review some differences in business structures.
Sole Proprietorship
This is a business entity with a single owner. There is no difference between the business and the business owner for legal and tax purposes. In this structure, the proprietor is responsible for all business liabilities.
LLC
A limited liability company (LLC) offers liability protection for its owners. Personal assets are protected from business losses. In an LLC, the owner or owners have direct ownership of the company rather than ownership represented in shares or stock.
LLCs have a less rigid structure than corporations and aren’t required to have quarterly meetings. LLCs also avoid double taxation on salaries. In some cases, an LLC can elect an S Corporation status.
Corporation
As we’ve discussed, corporations have rigid structures, require more paperwork, and have strict taxation rules. The flip side is that corporations allow for the most growth.
Once you’ve decided to form a corporation as your business entity, you can decide whether to elect S Corp status. While there’s no definitive way to tell you which tax status you should elect, some guiding questions can help you decide.
What is your growth plan?
Your business growth goals can help you determine what’s best for your company. If you plan to grow with equity financing, then a C Corp makes more sense. Equity financing is when you acquire capital to grow the company by selling shares to investors.
Suppose you’re courting venture capital investments, for example. In that case, your company should be a C Corp. Not only does that allow other corporate entities, like a venture capital firm, to invest, but most investors like to have more stock options than just common stock.
On the other hand, if you already know your ownership group and don’t think you’ll ever grow beyond 100 shareholders, an S Corp could make more sense.
Do you want to sell your company?
This question builds on the growth plan question. Sometimes, you might form a company with the intent to get acquired by a larger company. For example, a tech startup might intend to get bought out by a larger, more established tech company. If your plan is to get bought out, a C Corp is more attractive to prospective buyers.
Can you handle extra IRS scrutiny?
Most companies don’t want to fall under the IRS’s microscope. If you elect S Corp status and slip up, like selling shares to a non-US resident, you lose your status. However, if you’re confident you can follow the rules and don’t mind the extra eyes watching you, then the tax benefits of becoming an S Corporation make sense.
Is double taxation worth it?
This is really the crux of deciding between S Corp and C Corp. C Corps offer more advantages and growth opportunities and are less limited than S Corps. But S Corps avoid corporate tax. You need to decide if the benefits of being a C Corp outweigh the financial burden of double taxation.
Can my business change its corporate tax status?
When you first incorporated, you either remained a C Corp or elected to become an S Corp, but you may wonder if you can change your status. Companies might want to pursue a change because of a shift in the market, new tax legislation, or because of new growth opportunities.
When the 2017 Tax Cuts and Jobs act passed, many small businesses evaluated changing from S Corp to C Corp because of the lowered corporate tax. Then there were also C Corps that wanted to switch to S Corp because the same Act provided a 20% deduction for pass-through entities.
It might be possible to change the status, but it depends on your company and individual state laws. Always consult with your tax advisors when deciding on your tax status.
C Corporation vs. S Corporation – Final Thoughts
C Corporation and S Corp tax statuses offer various benefits and risks for your corporation. Avoiding corporate tax is an extremely attractive benefit, but do the pros of an S Corp outweigh the cons?
Your business must decide by carefully weighing the advantages of each against your specific business goals. If you know your company will remain privately held with fewer than 101 shareholders, S Corp might make more sense. If you want to build your company through equity financing or eventually go public, then a C Corporation is the way to go.
However, sometimes the question is not as definitive as that. Maybe you don’t have plans to go public now, but who knows what the future holds for your business.
No one can tell you the exact right answer. You should consult with your tax experts and your shareholders before deciding. It could be one of the first things your shareholders vote on.
