Trying to decide between an S corp vs. a C corp when incorporating your business could be tricky without knowing the two business-type entities properly. If you also want to know more about a limited liability company, check our devoted article - Pros and Cons of an LLC.
There is no one right solution for what is better when considering what structure you need for your business. However, understanding the difference between an S corp and a C corp would help guide you in the right direction for your company. Depending on your goals and the kind of business you want to make, both business entities have their own relative advantages and disadvantages.
Knowing how to tell if a company is an S corp or a C corp is a good place to start when beginning a business. This article would help you familiarize yourself and answer the questions: "What is a C corporation?", "What is an S Corporation?", and "What are the advantages and disadvantages of both business structures?".
What is a C Corporation?
C corporation or C corp is a way for corporations to be recognized for tax, regulatory, and official business. This legal structure, the most widespread of corporations, taxes owners, shareholders, and business entities separately. It is subject to a different tax treatment compared to an S Corporation, a sole proprietorship, and a limited liability company (LLC), among others.
Generally, a C Corporation is structured better for larger businesses, although a C corp could consist of only one person. If you intend to have publicly traded shares through an Initial Public Offering (IPO), a C Corporation would fit better for your company. C Corporations tend to attract more investors, such as venture capitalists and shareholders, allowing for a broader ownership structure.
C Corporations are also known for their double taxation, as the IRS taxes the business's profits at both the personal and corporate levels.
What is an S Corporation?
Also known as an S subchapter, an S Corporation (S corp) refers to a type of business structure that meets specific Internal Revenue Service Code requirements taxed under Subchapter S. If your business has only a few business partners or investors, then an S corporation could be the right choice for you.
An S Corporation tends to offer the best flexibility in how owners run their business. It leaves out some of the formalities and filing requirements associated with a C Corporation. Shareholders and other stake owners could freely transfer their ownership interest in the corporation without attaining the approval of other shareholders. This way, an S corp is more flexible than selling a shareholder's interest in an LLC.
Small businesses with 100 or fewer shareholders are often associated with an S corporation status. While enjoying the tax-exempt privileges of a partnership, an S corp gives regular benefits of incorporation to companies. However, this business structure still has some limitations that could not work with your business.
All shareholders should be U.S. citizens or U.S. legal residents, and an S Corporation should also be a domestic business entity.
Difference between S Corp and C Corp
The main difference between an S corp and a C corp business structure lies in how the two corporations pay their taxes. According to the Internal Revenue Service regulations, a C corporation is the default or standard status a business obtains after it registers. Meanwhile, an S Corporation possesses a special tax status with the IRS, giving it different tax advantages.
How to tell if a company is an S corp or a C corp? S corporations are taxed under IRS code Subchapter S, hence the name "S Corporation." Meanwhile, C corporations are taxed under Subchapter C of the IRS code. You could change your status from a C corporation to an S corporation election and filing federal form 2553 with the IRS.
If you have a C corporation, you must pay taxes based on income and additional tax on any income an owner and shareholder receive. On the other hand, if you become an S corporation, you would not need to pay taxes. Instead, you and other stakeholders count the corporation's revenue as their personal income, thus avoiding double taxation.
C Corporation Advantages
Most household-name businesses prefer to operate with a C Corporation status as this gives them advantages fit for their company. Here are some C corporation advantages that could work for your business.
As a separate legal entity, C Corporations limit the personal liabilities of the directors, investors, shareholders, employees, and officers from the liabilities of the business. This means that the corporation's legal obligations would not become a personal debt obligation of any individual associated with the company.
Unlimited number of shareholders
Under Subchapter C, a corporation has no limit on the number of shareholders it can have. However, the Securities and Exchange Commission (SEC) requires you to register upon reaching specific thresholds.
No restrictions on ownership and classes
When it comes to ownership, anyone can own shares, including non-U.S. citizens and business entities. C corporation could also issue more than one class of stock. This includes stocks with preferences to distributions and dividends.
Ownership of C Corporations are transferable and can be fluid. It is also decided by who holds the stocks the corporation issues.
More options for raising capital
According to the IRS tax code, C corporations do not have the same restrictions on ownership, unlike S Corporations. This means it is easier for a C corp to acquire equity financing. It could also hold an "Initial Public Offering (IPO)," as a C corp is often the best choice for companies to obtain venture capital funding from investors. IPOs also give businesses the opportunity to grow and go public.
Exists independently of its owners
Changing the status of your corporation to a C corp would give your business a "Perpetual Existence." This means that the corporation exists until its owners, shareholders, and other stakeholders decide to end it.
More options for raising capital
If a C corp wants to raise funds, it could hold an "Initial Public Offering (IPO)," where ownership is decided by who holds the stocks issued. C Corporations could also obtain equity financing easier than an S corporation could because the tax code does not enact the same restrictions to a C corp.
Disadvantages of a C corporation
While having a C corporation status presents you with many benefits, you need to keep in mind that there are drawbacks as well. Here are three major disadvantages to consider.
Unlike a limited liability company (LLC) or an S corporation, a C corporation is more complex to operate, as corporation laws require more formalities in managing a corporation. C corporation laws also tend to have stricter record-keeping requirements, such as keeping detailed minutes of the meeting for every shareholder and director meeting.
As a C corporation, your business is a separate tax-paying entity unless the owner and shareholders make an election to change its status to an S corporation. After offsetting income with deductions, credits, and losses, C corp would pay corporate income tax on its income. The shareholders then pay their individual income taxes on the dividends paid by the corporation from its after-tax income. This is what is commonly known as "double taxation." Although, there are ways to lessen or even eliminate double taxation that an accountant could recommend.
Regulations and Formalities
Corporations taxed under IRS code subchapter C experience more government oversight compared to other companies. Complex tax rules and the protection business owners receive from being responsible for the company's financial obligations such as debts and lawsuits make C corporations observe certain formalities. Corporations need to report to states where they are incorporated and states where they conduct most of their business on a yearly basis.
Additionally, your business has to make its corporate officers public, unlike other organizational structures that do not.
S Corporation Advantages
No corporate income tax
Unlike a C corporation, which pays corporate income taxes on corporate revenues, an S Corporation is exempt from corporate income tax.
Eliminates double taxation
Double taxations occur when the company's profits are taxed twice – first as corporate revenue and second as dividend income. For C corporations, the company pays a dividend to its shareholders. Then, those shareholders owe taxes on their dividend income. An S corporation owner avoids this tax implication as it is exempt from tax on dividends.
After changing your status to an S corporation, the IRS would treat your company as a "pass-through entity" for tax purposes. This means that, instead of paying corporate income tax or paying taxes on dividends, your S corporation's income simply "passes through" to your personal tax returns. This is also true for limited liability companies (LLCs) or sole proprietorships.
Flexibility in the tax treatment of income
When it comes to tax purposes, an S corporation would give you more flexibility with how you characterize your income. Although, it depends on your marginal income tax bracket and overall tax situation. You could select to have a part of your corporate income paid to you as a "distribution" of revenue from the business and another part as an employee salary.
Properly setting up your salary and distribution amount could help you manage taxes efficiently and possibly decrease your tax burden.
As an S corporation, the business owner has certain legal protections for their personal assets separate from the company's assets. For example, creditors cannot go after the shareholders' or owner's personal assets to recover business debts. This means that shareholders are not liable for the corporation's obligations or liabilities personally.
Easy transfer of ownership
You could easily transfer the ownership interests of your S corporation to other owners without causing significant tax penalties or corporate entity termination. Transfer of ownership does not require adjustments to property basis or compliance with complicated accounting regulations.
Disadvantages of an S Corporation
IRS inspection of wages and dividends
Due to the nature of an S corporation's ability to characterize incomes as wages and dividends to avoid paying payroll taxes, the IRS inspects how an S corp compensates its employees. The agency is always on the lookout for companies that are not accurate or reasonably specify their wage payments.
Restrictions on ownership
Unlike C corporations, S corporations do not have the same flexibility in their ownership structure. If you decide to change your business to have an S corp status, you could only offer one class of stock. This limits the appeal to different kinds of investors. Additionally, an S corporation could only have a maximum of 100 shareholders, which should all be U.S citizens or legal residents.
Hard to obtain equity financing
Due to the restrictions on ownership of an S corporation, it would make it hard for your business to obtain equity financing. This is particularly true because private equity and venture capital funds tend to be unqualified as shareholders.
Most S corporations would restrict their shareholders' ability to transfer or sell their stock shares. This ensures that they do not end up with an ineligible shareholder, which could cause the IRS to terminate their S corporation status.
Conclusion: Deciding Between an S Corp vs. C Corp
Depending on your overall goals for your business, the decision between S corp vs. C corp could become complicated and arduous.
Suppose you want your company to grow significantly for the long-term, where you could have an Initial Public Offering and have an unlimited number of shareholders. In that case, you should consider staying or incorporating as a C corporation.
C corp would give your business many C corporation advantages, such as making your business exist independently of its owners. However, a Subchapter C corporation has its own downsides, such as having extra tax obligations and complex operations compared to an S corporation.
On the other hand, if you want to have status with unique tax advantages and only allow a maximum of 100 shareholders who are all legal residents or citizens of the U.S., consider incorporating as an S corporation. Like a C corporation, an S corporation also presents disadvantages such as restriction on ownership and difficulty obtaining equity financing.
Before making the decision to stay as a C corporation or elect to change as an S corporation, consider talking with an accountant or tax attorney. Your overall business goal and tax obligations could determine the structure of your business entity and even your compensation.
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