What’s the difference between an S Corp and C Corp?

The main difference between an S Corp and a C Corp is that for a C Corp, the corporate profit is taxed to the company, and the dividends to the shareholders are also taxed. In contrast, for an S Corp, the profit is taxed to the shareholder but not to the corporation. Generally, small businesses are S Corps, and major companies are C Corps, e.g., Apple, Microsoft, Caterpillar, John Deer, etc.

Author: Brad Nakase, Attorney

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Introduction

The primary difference between an S corp and a C corp is how the IRS taxes them. The terms “C-corp” and “S-corp” refer to tax classifications that are available to both corporations. When a corporation is formed, by default, the entity is a C corporation is the standard under IRS rules. After formation, an S corporation is elected for special tax status with the IRS. C corporations exist as the default corporate tax structure. C corporations face double taxation, meaning they pay corporate and individual income taxes on capital gains and dividends. An S corporation is a corporation that elects to be taxed as a pass-through entity. Income, losses, deductions, and credits flow through to the shareholders, partners or members. Another important distinction is that S corporations only have one class of stock, while C corporations may have multiple stocks.

S Corps and C Corps have one main difference: taxes. A C corporation pays tax on its income. An owner of a C Corp will also pay tax on the income he or she receives as owner. By contrast, an S Corporation does not pay tax. The owner of an S Corporation will instead report the company’s revenue as personal income.

However, there are a couple other differences in addition to taxation. Let’s review these.

  • Formation

When a corporation is formed, it will by default become a C Corporation. This means that when a business owner files articles of incorporation in his or her state, the company will be called a C Corporation. If the company wants to instead become an S Corporation, the owner will need to file Form 2553. It is possible that there will be additional forms to fill out to maintain S Corp status.

  • Taxation

As discussed above, one of the major differences between C Corps and S Corps is taxation. C Corporations are taxed twice. The company must pay corporate income tax and shareholders must pay federal income taxes via dividends. This is called double taxation. By contrast, S Corporations have pass-through taxation. In this case, shareholders include business income and losses on their personal tax returns. This means that the only taxes they need to pay are those on their personal tax return. An S Corp does not have a corporate tax.

  • Ownership

C Corps do not have any restrictions regarding ownership. This means that anyone can be an owner, and a corporation can have as many owners as it wants. S Corps do not have this freedom. An S Corp can only have 100 shareholders, and these must be U.S. citizens.

Overwhelmingly, small businesses in the United States are S Corp.

What is an advantage of an S Corp?

The tax benefit for S corporations is that business income, as well as many tax deductions, credits, and losses, are passed through to the owners, rather than being taxed at the corporate level.  The shareholder only need to provide business income and losses on their personal income tax returns. In general, an S Corp can deduct up to 20% of business income on a personal tax return. This means that if a business owner has an S Corp, he or she can write off any business losses on his or her personal tax return.

What is a disadvantage of an S Corp?

While an S Corp definitely has tax benefits, it should be noted that the IRS pays much more attention to S Corp tax filings than C Corps. An S Corp does not have to pay double taxation, but the IRS still watches more carefully. If the IRS finds a mistake in an S Corp’s filings, it can cancel the corporation’s status as an S Corp.

In general, S Corps are watched closely by the IRS, meaning they have to follow all the rules laid out for S Corps very carefully. Breaking any of these rules could result in the company losing S Corp status. This means that an S Corp cannot have over the 100-shareholder limit or have a shareholder who is not a U.S. citizen. Also, because an S Corp can only have one class of stock, unlike C Corps, company growth can be limited. Therefore, a business that plans for a lot of fast growth or wants to do international business may not be best suited for an S Corp.

It is also important to note that S Corps cannot be owned by other S Corps, C Corps, LLCs, or trusts. If a company would like to be acquired at some point, then an S Corp may not be the correct status for the business’ goals.

C Corp Advantages

Great for equity financing and attractive to investors because of the well-defined ownership, management and tax structure.

While S Corps get the reputation for tax benefits, C Corps aren’t all that bad. A business owner can deduct 100% of charitable donations and contributions on the corporate tax return. The exception to this would be if the donations exceed 10% of the company’s income. An owner can also help his or her employees by deducting benefits like health insurance. Of course, double taxation is a negative. That said, the 2017 Tax Cuts and Jobs Act capped taxes for C Corps at 21%.

One positive about C Corps is that ownership is not subject to any restrictions. A C Corp is a good business structure for an owner who is considering the following:

  • Selling the company in the future
  • Looking for investor funding

Also, a C Corp can have as many shareholders as it wants, and they do not have to be U.S. citizens. This means that selling stock to investors is much easier for a C Corp. If there is an investor in Hong Kong with millions to offer a company, he or she can become a shareholder. C Corps can also be owned by other C Corps, S Corps, or trusts.

C Corp Disadvantages

When a company files articles of incorporation, it automatically becomes a C Corp. But just because it is the default option does not mean it is the right choice for one’s company. Even a growing company does not necessarily want to be acquired to get funding from investors. A C Corp is generally good for big companies that want to become even bigger. But perhaps an owner has a small company and is happy with it at that size. In this case, an S Corp might be a better option.

One of the biggest disadvantages for a C Corp is double taxation. A company’s revenue is taxed, and the owner is taxed again for personal returns. So, a C Corp is losing money twice on revenue earned. This is a particular disadvantage for small businesses that may not be able to afford to be taxed twice. Paying taxes at the corporate level take a big bite out of earnings. C Corps also do not allow owners to make tax write-offs on their personal income tax returns.

It is true that C Corps do not have ownership restrictions or limits on stock. That said, a business owner will still need to conduct proper management. This means that an owner will still need to issue stock to shareholders and hold meetings for the board and for shareholders. An owner may also have to pay fees in order to maintain C Corp status. Therefore, even with increased freedom, a C Corp comes with necessary management formalities that must be observed.

S Corp and C Corp Similarities

So far, we have focused on the differences between C Corps and S Corps. But there are also notable similarities that these types of corporations share. Let’s review these similarities, which are important for anyone considering incorporation to know.

  • Limited Liability Protection

Both types of corporations share limited liability protection. This means that shareholders are not liable, or responsible, for a company’s debts or obligations. If the company were to face a lawsuit or other legal action, then a shareholder would not have to pay out of pocket to cover any debt or judgement. Personal assets are also safe, so no one has to worry about losing their house, car, or personal savings.

  •  Separate Legal Entities

Both C Corps and S Corps are able to use separate legal entities. In this case, a company may choose to operate as an entity separate from its original company. A separate entity allows for liability to be separate from its ownership. Separate entities are therefore protected by a corporate veil, which means protection from liability.

  • Filing

Whether a company decides to become an S Corp or C Corp, a business owner will file the same articles of incorporation with the state. This means that there is no difference in the documents. An S Corp will need to file a little more paperwork, but the articles of incorporation are the same for both.

  • Structure

S Corps and C Corps are both free to have their own shareholders and ownership structure. Both types of corporations may issue stock and have bylaws. Both types of companies also have boards of directors. They both must also file annual reports.

  • Formalities

For both S Corps and C Corps, the company is managed by a CEO and the board he or she puts together. A board of directors manages company policy and management matters.

Which One is Best?

When a company files its articles of incorporation to become a corporation, it is automatically made a C Corp. However, that does not mean this is the best option for the company. Each business has its own needs. In order to determine what is best for his or her business, a business owner should ask themselves a series of questions.

Do I want to sell my company?

If a business owner plans on one day selling his or her company, then it may be a better decision to become a C Corp. This is because C Corps have the ability to be owned by other types of companies. Therefore, acquisitions are made easier if the corporation is a C Corp.

Do I want to have limited shareholders?

Not all companies want to expand or become mega-corps. Some small businesses are okay with remaining small. S Corps are better suited to these types of companies, because they limit companies to 100 shareholders. They also require that shareholders be U.S. citizens. However, even with a smaller number of shareholders, S Corps rely more on shareholder input. If a company likes having more shareholder involvement and opinions, then this can be a positive setup. However, if a company plans to grow significantly down the road, then a C Corp may be a better option.

Am I okay with double taxation?

The biggest difference between S Corps and C Corps is the matter of double taxation – essentially the fact that C Corporations have a corporate tax. If a business owner is okay with being taxed first at the corporate level and then again at the personal level, then a C Corp should not be a problem. If a business owner would prefer not to pay a corporate tax, he or she can. Instead, they will manage profits and losses through their personal income tax.

Am I comfortable with extra scrutiny?

When a corporation files its articles of incorporation, the default is for it to be assigned C Corp status. To become an S Corp, a company faces an extra round of paperwork. In general, S Corps are watched more carefully by the IRS. Therefore, it is important for S Corps to have very clean records without any mistakes. Even a small mistake can result in the loss of a company’s S Corp status. For instance, accidentally having 101 shareholders can lose a company S Corp status. However, some business owners are okay with having the IRS keeping a watchful eye over them. As long as a business follows the rules, then an S Corp would not be a problem. If, however, this prospect causes a business owner too much stress, then a C Corp may be a better option.

Are there other options?

It could be that neither an S Corp or a C Corp suits a business owner’s company. Luckily, there are other options. A business owner can choose a partnership, a trust/estate, a sole proprietorship, or a limited liability company (LLC). If a business owner plans on being the only member of the company, then a sole proprietorship or LLC may make the most sense. However, it is important to remember that as a sole proprietor, business finances and personal finances are tied. This means that if the company takes on debt, the owner is personally responsible for paying it off. If the debt is not paid, then the owner might lose his or her assets to pay for the debt. These assets could include houses, cars, and personal savings. The same goes for lawsuits. If the company is sued, then the business owner is liable for any damages the company incurs.

A limited liability company, however, avoids these issues. For the owner of a limited liability company, personal liability is limited to the investment he or she puts into the company. The owner of an LLC is protected in the event of lawsuits or debt. This is because the company is separate financially from the owner. In the event of debt or a lawsuit, the owner is not responsible for paying damages. The owner’s personal assets are therefore safe. Having an LLC also means one has a better chance of getting funding or loans. However, there is more paperwork involved in becoming an LLC than there is in becoming a sole proprietorship or partnership.

A business owner will need to analyze the needs and characteristics of his or her company and decide what entity type best suits it.

Example A: Holly and Alex are the owners of an animation software company. They are considering becoming either an S Corp or a C Corp. Their goals for the business include growing the company to a larger size and bringing in investors, especially some from overseas. They need a lot of money for their animation projects and would one day like to sell the company to a larger film studio. For their needs, a C Corp is the best option.

Example B: Louise is the owner of a cupcake shop. After two years of good business in the local community, she would like to take her company to the next level. Her friends have told her to become either an S Corp or a C Corp. Louise, however, does not really want to bring on more people such as shareholders. She would, however, like to have liability protection in order to protect her personal assets. Based on her needs, she decides that a limited liability company (LLC) is the best option.

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