Before you make your decision, make sure you understand the pros and cons of each.
Corporation basics
C corporations and S corporations have quite a bit in common. Owners of a corporation are called shareholders, and they elect directors to oversee business operations. The directors hire officers to manage the day-to-day operations. Profits, called dividends, are distributed to shareholders according to the number of shares each owns.
A corporation is formed by preparing a document called articles of incorporation, and filing registration documents with the state.
Corporations are required to issue stock, adopt by-laws, hold annual director and shareholder meetings, keep minutes of meetings, issue written corporate resolutions for significant decisions, and file annual reports with the state government and pay annual fees. Failure to do these things can result in the loss of personal liability protection and dissolution of the corporation.
Setting up a corporation provides limited personal liability for its owners. A corporation is set up under state law, and is legally a separate entity from the owners. As a separate legal entity, only assets of the corporation are subject to corporate debts. Although there are some exceptions, a shareholder is not personally liable for corporate debts, and assets of the shareholder are protected from business creditors.
While there are similarities between C corporations and S corporations, there are also some stark differences.
Formation
All corporations begin as C corporations. A C corporation may be converted to an S corporation by filing IRS Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service (IRS). There may also be state forms to file to obtain S corp status for state tax purposes.
It is called an “S” corporation because the provisions in the law that permit it are found in Subchapter S of Chapter 1 of the Internal Revenue Code.
To obtain S corp status for a certain year, Form 2553 must be filed no later than March 15 of that year for corporations operating on a calendar year basis. For corporations operating on an alternative fiscal year, it must be filed no later than the 15th day of the third month of the fiscal year. Of course, it can also be filed at any time during the previous tax year.
Taxation
The main reason for choosing an S corp is to save on taxes. There is a big difference in how a C corp and an S corp are taxed.
For federal tax purposes, C corporation profits are taxed, and are reported on the corporation tax return. Any after-tax profits distributed to shareholders as dividends are taxed again, and are reported by the shareholders on their personal tax returns. T
his “double taxation” can be avoided by electing S corp status for your corporation. An S corp. is treated similar to a sole proprietorship or a partnership. The profits (or losses) are passed through the S corp. to the shareholders, and are only taxed to the shareholders and reported on their personal tax returns.
Many states also pass profits and losses through to the owners of S corporations. However, a few states engage in double taxation of S corps.
Ownership
A C corp. will provide more flexibility regarding selling shares of stock. According the IRS, a corporation that elects S corp. status may not:
- Have more than 100 shareholders
- Issue more than one class of stock
- Have shareholders who are not U.S. citizens or residents
- Be owned by a C corporation, other S corporations, LLCs, partnerships, or various trusts
None of these restrictions apply to C corporations, which can help the company grow larger. For example, having more than one class of stock can help a business raise capital from investors without giving them voting rights.
Additional benefits
A company may want to provide certain benefits to shareholders who are employees, such as health, life, and disability insurance. With a C corp., the cost of such benefits can be deducted by the corporation, and are not taxable to the shareholder as long as the benefit is provided to at least seventy percent of the employees.
An S corp. cannot deduct the cost of benefits, and they become taxable to a shareholder who owns more than two percent of the stock.
Which is best for you?
Generally, S corp. status is preferred by small businesses, which usually fit within the legal limitations for an S corp. Certain types of corporations find more advantages with a C corp.
An S corp. is often not available to large corporations, those with a lot of start-up capital and large ambition, or those planning to sell stock globally. Large corporations may want the flexibility of being able to have more than 100 shareholders, sell shares to investors who are not U.S. citizens or resident aliens, have shares owned by other entities (corporations, LLCs, partnerships, trusts, etc.), or issue more than one class of stock.
Generally, an S corp is more popular with smaller businesses because of the likely tax savings, and a C corp is more popular with larger companies because of the greater flexibility to raise capital. However, whether a C corp. or S corp. would be best for your business is dependent upon careful analysis of various factors as they relate to your particular situation.