Should you file as an S Corporation or a C Corporation? Choosing the right business entity comes with significant legal and financial implications.
S Corps are ideal for smaller businesses that want to avoid double taxation, while C Corps may be able to access lower corporate tax rates. S Corps offer more flexibility in ownership and management, while C Corps have the credibility and growth potential that comes with being a separate legal entity.
To determine whether you should form an S Corporation vs. a C Corporation, let's start with the definition of a "corporation" and then dive into the differences between the two corporate structures.
Corporations, Defined
A corporation is a type of business entity separate from its owners with a legal existence of its own. Corporations can enter into contracts, file lawsuits, sue other parties (as well as be sued), own assets, and issue stocks to raise capital.
All corporations are governed by a board of directors and have shareholders who purchase and own stocks in the company. The owners don't pay taxes based on the profits and losses of their corporation; instead, the corporation itself is taxed separately from its owners' personal income. Any shareholders are then protected with limited liability, which means they cannot lose personal assets if the business in which they own stock performs poorly.
Sometimes, parent corporations (often referred to as holding companies) can form new corporations (owned by the parent corporation) designed to focus on separate but often related ventures.
What Is an S Corporation?
An S Corporation, or S Corp, is named after Subchapter S in the Internal Revenue Code. S Corp is a tax status that separates the business from its shareholders, offers limited liability protection, and permits pass-through taxation.
What Is a C Corporation?
A C Corporation, or C Corp, is named after Subchapter C in the Internal Revenue Code. C Corps are taxed as separate legal entities, provide limited liability protection to shareholders, and are subject to double taxation.
Differences Between S Corps and C Corps
S Corporations and C Corporations have different tax implications and requirements. Let's dive a little deeper into the main differences between an S Corporation and a C Corporation:
Taxation
The biggest difference between an S Corporation and a C Corporation is the taxation structure:
- S Corps are taxed as pass-through entities, meaning the business income, deductions, and credits flow through to the shareholders and are reported on their personal tax returns.
- C Corps are taxed as separate legal entities, meaning that the corporation is taxed on its profits, and the shareholders are taxed on any dividends they receive. This results in double taxation for C Corps, which can be a turn-off for some business owners.
Shareholder Limitations
- S Corps have restrictions on the number and type of shareholders they can have, such as a limit of 100 shareholders and a requirement that all shareholders be U.S. citizens or at least U.S. residents.
- C Corps can have unlimited shareholders including non-resident aliens.
Reporting Requirements
- S Corps require basic annual reporting.
- C Corps are subject to more complex regulations and reporting requirements than S Corps and must file annual reports with the Securities and Exchange Commission (SEC).
Ownership Structure
- S Corps are owned by individuals. S Corps are best for businesses looking for a tax-efficient structure with fewer restrictions on ownership and reporting.
- C Corps can be owned by individuals, other corporations, or a combination of both. C Corps are suitable for businesses looking to raise a large amount of capital and have more complex ownership structures.
Benefits of an S Corp
Pass-Through Taxation
One of the main benefits of an S Corp is that they are taxed as pass-through entities, thus avoiding double taxation, which can result in lower overall tax liability for the owners. The profits and losses of the business flow directly to the individual tax returns of the owners, known as shareholders.
As a result, the business itself is not subject to federal income tax. This can be a significant advantage, as it can result in lower tax liability and simplify tax preparation for the owners.
Liability Protection
S Corps provide liability protection to their owners, similar to a corporation. This means that the personal assets of the owners are protected from business debts and liabilities.
This provides peace of mind for the owners, as they don't have to worry about losing their personal assets if the business experiences financial difficulties. Liability protection can be an attractive feature for potential investors and lenders as it reduces their risk in doing business with the company.
Flexibility
S Corps offer more flexibility in terms of ownership and management compared to C Corps. They can have up to 100 shareholders and don't have the same strict regulations and reporting requirements. This makes it easier for owners to manage the business, as they have more control over the day-to-day operations and decision-making processes.
Additionally, S Corps can have shareholders who are foreign citizens or entities, which can make it easier to expand globally if that's part of the plan.
Credibility
The benefits of an S Corp also include credibility, as they are seen as a legitimate enterprise by the public. This can help build trust with customers and suppliers, which is essential for the success of any business.
Also, S Corps have the ability to raise capital and attract investors. This can be beneficial for businesses looking to grow and expand, as they can access the capital they need to do so.
Potential Tax Savings
Because S Corps are taxed as pass-through entities, the owners can take advantage of deductions and credits that are not available to C Corps. This can result in potential tax savings for the owners.
For example, owners can deduct the costs of business-related expenses, such as health insurance and retirement plan contributions, from their individual tax returns. This can help reduce the overall tax liability for the owners and maximize their profits.
Furthermore, as an individual owner, you can pay yourself a salary and then pay yourself additional funds as a distribution from the S Corporation without being required to pay self-employment tax on those additional funds.
Simplified Record-Keeping
The benefits of an S Corp include less complex reporting requirements than C Corps, which can simplify record-keeping and reduce the costs associated with compliance. This can be especially beneficial for small businesses, as they may not have the resources to keep up with the reporting requirements of a C Corp.
S Corps are also only required to file an annual report with their state, which can be less time-consuming and less expensive compared to the reporting requirements of a C Corp.
Benefits of a C Corp
Separate Legal Entity
One of the main benefits of a C Corp is that it functions as a separate legal entity from its owners, offering them liability protection. This means the shareholders' personal assets are protected from business debts and liabilities, giving them peace of mind. Additionally, the separate legal status of C Corps can provide the business with greater credibility, which is important for attracting both customers and partners.
Liability Protection
C Corporations offer personal asset protection to their owners, shielding them from business debts and liabilities. This gives owners peace of mind against financial risk. This protection of personal assets is one of the key reasons why many entrepreneurs and business owners choose to form a C Corp. And of course, liability protection is an attractive trait for potential investors and clients.
Ability to Raise Capital
C Corporations can raise capital through the issuance of stocks, making it easier for them to attract investors and grow the business quickly. This can be especially beneficial for businesses looking to expand rapidly, as they have the ability to raise the funds necessary to support their growth plans.
Unlimited Number of Shareholders
C Corporations have the advantage of being able to have an unlimited number of shareholders including non-resident aliens. This makes it easier for businesses to bring in outside investment and expand their ownership base, as they are not limited by the number of shareholders they can have.
Potential for Lower Corporate Tax Rates
Another benefit of a C Corp is that they are taxed as separate legal entities. The corporate tax rates for C Corps may be lower than the individual tax rates for the owners of a pass-through entity like an S Corporation. This can result in significant tax savings for the business and its owners.
Flexibility in Allocating Profits
C Corporations have the flexibility to allocate profits and distribute dividends to shareholders in a manner that best suits the needs of the business. Depending on market conditions and your business goals, a C Corp can reward shareholders while prioritizing your company's growth and reinvestment.
Increased Credibility
C Corporations have the credibility and prestige associated with being a corporation, which can be especially important for businesses looking to attract both customers and partners. This increased credibility can help to build the confidence needed to attract investment and expand the business.
Growth Potential
The benefits of a C Corp also include the ability to help businesses grow and expand. With the ability to raise capital and attract investment, C Corps have the resources and flexibility needed to support their growth plans and achieve their goals.
S Corp vs. C Corp Tax Benefits
What are the tax differences between an S Corp and a C Corp? Both offer tax benefits, but have different implications in terms of double taxation, liability protection, and flexibility.
- S Corps are considered pass-through entities, meaning the business income, deductions, and credits flow through to the shareholders and are reported on their personal tax returns. This allows the business to avoid double taxation and can result in lower overall tax liability for the owners. S Corps can also take advantage of deductions and credits that are not available to C Corps, resulting in potential tax savings.
- C Corps are taxed as separate legal entities, and their profits are subject to corporate income tax. However, the corporate tax rates for C Corps may be lower than the individual tax rates for the owners of a pass-through entity like an S Corp. Additionally, C Corps have the flexibility to allocate profits and distribute dividends to shareholders in a manner that best suits the needs of the business.
Drawbacks to Filing as a Corporation
S Corporation vs. C Corporation aside, incorporating a business as opposed to forming an LLC can offer many benefits — but there are also some drawbacks that should be considered before making the decision to incorporate. These are some of the main drawbacks of filing as a corporation.
Complexity and Cost
Forming a corporation can be a complex and costly process that requires legal and accounting services as well as ongoing compliance and reporting. This can burden smaller businesses, taking time and resources away from running the company.
Increased Regulations
Corporations are subject to a higher level of regulation and reporting requirements than other business structures such as sole proprietorships or partnerships. This can result in increased administrative costs and reduced flexibility in making decisions.
Double Taxation
C Corps are taxed at the corporate level and then again when profits are distributed to shareholders as dividends. This double taxation can reduce the overall profitability of the business.
Shareholder Approval
Decisions in a corporation often require shareholder approval, which can slow down the decision-making process and limit the ability of the owners to act quickly.
Loss of Control
Once a corporation is established, ownership is typically dispersed among multiple shareholders, which can result in a loss of control if you were one of the original owners.
Limited Liability
While incorporating a business can provide liability protection for the owners, it isn't a guarantee. In some cases, owners may still be held personally responsible for business debts and liabilities.
For example, if a business owner uses their personal property as collateral for a business loan, the property may be sold to cover outstanding debts if the business should become delinquent. Additionally, if a business owner commits fraud, liability protection may be void and the owner could be held personally liable.
Which Corporation Is Right for My Business?
Determining whether to form an S Corporation vs. C Corporation comes down to the type of business you run, whether you want to scale it significantly, which tax structure benefits you the most, and how much control you want to have over your business in the long run.
Businesses that wish to grow, scale, and go public would be best served by filing as a C Corp, while businesses wishing to stay on the smaller side and avoid double taxation would be better off choosing to file as an S Corp.
If you still aren't sure whether you should choose an S corp or a C corp, you can take our free Business Entity Quiz to narrow down your options.
Common Questions About Corporations
Is an LLC an S Corporation or a C Corporation?
No. A Limited Liability Company (LLC) is a type of business structure that provides the limited liability protection of a corporation with the flexibility and tax benefits of a partnership or sole proprietorship.
An LLC is considered a separate legal entity from its owners, called "members," and is responsible for its own debts and liabilities. The members' personal assets are typically protected from the liabilities of the business, but members are still responsible for paying taxes on income generated by the business.
How Do You Know If a Corporation Is S or C?
To determine if a corporation is an S Corp or a C Corp, you can check with the Internal Revenue Service (IRS) to see how they have elected to be taxed. To be taxed as an S Corp, a corporation must file an election with the IRS using Form 2553. This must be done within a specific time frame and the corporation must meet certain eligibility requirements.
The organizational structure of a corporation can also indicate if it is an S Corp or a C Corp. S Corps are typically small, closely held businesses, while C Corps are typically larger, publicly traded companies.
When Should I Switch From S Corp to C Corp?
Typically, a business might consider switching from an S Corp to a C Corp if it experiences significant growth and expansion or if its ownership and tax structure change. If a business intends to go public in the future, it must be structured as a C Corp, as S Corps are not eligible for public offerings.
Form Your S Corp or C Corp With Incfile
Choosing the right business entity for your company can have a significant impact on its growth, success, and overall financial health. Both S Corporations and C Corporations have unique benefits and drawbacks. Making the right choice will depend on the specific goals, needs, and priorities of your business.
Incfile can help you take the first steps. Our corporation formation service provides you with everything you need to get your business off the ground, from registering with the state to obtaining necessary licenses and permits.
Chad Ruppert
Chad is a freelance writer and former project manager focused on presenting information on SaaS, technology and business formation.
