So you’re setting up a new business and have decided that a corporation makes the most sense. But what type of corporation are you looking for? That’s why an S-Corp vs C-Corp analysis is so critical.
Setting up an incorrect tax structure can have substantial tax impacts. It can result in significant variations in employment taxes, double taxation, and administrative headaches.
In this guide, we examine the S-Corp vs C-Corp. The goal is to select an entity that suits your business and reduces your overall tax liability. Let’s jump in.
Why is a business structure so important?
Once you decide to set up a business, you have a lot of tax considerations. Of course, you have a business to run, but you also have tax returns to file. The tax structure becomes critical, depending on the goals of the organization.
You’ll need to ask the following questions first before you set up the structure, let alone an S-Corp or a C-Corp:
- How many owners do I expect to have in the business?
- Do I expect to sell stock or ownership at some point in the future?
- Do I expect income or losses in the early years of operations?
- Are there any personal tax considerations before I set up the business structure?
Once the above questions are answered, you’ll better understand whether an S Corp. or a C Corp. makes the most sense. For example, if you plan on selling shares in the company at some point in the future, a c corp might make the most sense. In contrast, an S corporation is your best choice if you want to avoid double taxation.
But make sure you address these issues upfront. While many structures will allow you to change the tax structure going forward? It is certainly easier to set it up correctly in the first place. This can avoid any mitigating tax issues or IRS pitfalls.
What is an S Corp?
An S corporation is a specific business structure combining a corporation’s limited liability protection with a partnership’s tax benefits.
In an S corporation, the business income, losses, deductions, and tax credits are passed on to the shareholders, who must report them on their tax returns. This means the business does not pay federal income tax, but the shareholders are responsible for paying taxes on their share of the company’s income.
To qualify as an S corporation, the business must meet specific requirements set by the Internal Revenue Service (IRS), including having no more than 100 shareholders who are all U.S. citizens (or residents) and having only a single class of stock. Additionally, some states have their own requirements for S corporations.
What is a C Corp?
A C corporation, also called a regular corporation, is a particular business structure that is a separate legal entity from its owners (shareholders). In a C corporation, the business files its own tax returns and pays taxes on its profits at the corporate tax rate, which is generally higher than the individual tax rate.
One of the main advantages of a C corporation is that it offers limited liability protection to company shareholders. This means their personal assets are generally not at risk if the corporation faces legal or financial issues. Additionally, C corporations can issue multiple classes of stock and have unlimited shareholders.
However, one of the disadvantages of a C corporation is that it is subject to double taxation, meaning that it pays taxes on its profits. Then shareholders also pay taxes on any dividends they receive. This can often result in a higher overall tax liability for both the corporation and the shareholders.
Large businesses often use C corporations that plan to reinvest their profits back into the company for growth and expansion rather than paying out dividends to shareholders.
What are some of the advantages of an S Corporation?
There are several advantages of an S corporation, including:
- Pass-through taxation: As mentioned earlier, an S corporation does not pay federal income tax. Instead, the business income, losses, deductions, and tax credits are passed through to the specific shareholders, who include them on their tax returns. This allows the business to avoid the double taxation that C corporations face.
- Limited liability protection: Similar to C corporations, S corporations provide limited liability protection to all shareholders, meaning that their personal assets are typically not at risk if the corporation faces legal or financial issues.
- Flexibility: S corporations offer more flexibility than C corporations regarding management and ownership. S corporations can have up to 100 shareholders, who can be individuals, trusts, estates, or certain types of organizations. Additionally, S corporations can have different classes of stock with varying voting rights.
- Access to financing: S corporations may be more attractive to investors than sole proprietorships or partnerships, as they offer the limited liability protection available to corporations with the pass-through taxation benefits of a partnership. This can make it easier for S corporations to attract outside investment and secure financing.
- Tax benefits for shareholders: Shareholders of S corporations may be eligible for specific tax benefits, such as the ability to deduct certain business losses on their individual tax returns.
Overall, S corporations can offer significant tax and liability benefits for small businesses and their owners while providing the flexibility and access to the financing needed for growth and expansion.
What are the differences between a C-Corp and an S-Corp?
There are several significant differences between C corporations and S corporations, including:
- Taxation: C corporations are taxed as separate entities and must pay federal income tax on their profits. In contrast, S corporations do not pay federal income tax; the business income, losses, deductions, and specific credits are passed through to the shareholders/owners, who report the items on their personal tax returns.
- Ownership and number of shareholders: C corporations can have an unlimited number of company shareholders and can issue multiple classes of stock. In contrast, S corporations can have no more than 100 shareholders, all of whom must be U.S. citizens or residents, and can only have one class of stock.
- Eligibility: Not all businesses are eligible to be S corporations. To qualify, a company must meet specific requirements set by the Internal Revenue Service (IRS), including having no more than 100 shareholders who are all U.S. citizens or residents and having only one class of stock. Additionally, some states have their own requirements for S corporations.
- Formalities and compliance: C corporations are generally subject to more formalities and compliance requirements than S corporations. For example, C corporations must hold annual shareholders meetings and maintain detailed corporate records, while S corporations have fewer formalities.
- Double taxation: C corporations will be subject to double taxation, meaning that the corporation must pay taxes on company profits, and then shareholders also pay taxes on any dividends they receive. In contrast, S corporations avoid double taxation, as the business income is passed through to the shareholders and taxed only once at the individual level.
C corporations and S corporations have different taxation, ownership, eligibility, and compliance requirements. Businesses must carefully consider these factors when deciding which type of corporation suits their needs. A careful analysis of S-Corp vs C-Corp is required.
How do you form a corporation?
Forming a corporation involves several steps, which may vary depending on the state where the corporation is being formed. Here is a general overview of the steps involved in forming a corporation:
- Choose a name for the corporation: The name must not already be used by another state business and must meet the state’s naming requirements.
- File articles of incorporation: This document formally establishes the corporation and includes information such as the corporation’s name, location, purpose, and ownership structure. The document and a filing fee are typically filed with the state’s Secretary of State office.
- Draft bylaws: Bylaws are the company rules and procedures that govern how the corporation will operate. They typically include information such as the roles and responsibilities of directors and officers, meeting procedures, and how the corporation will handle financial matters.
- Hold an organizational meeting: This is the first meeting of the corporation’s board of directors and is typically held after the articles of incorporation are filed. During the meeting, the bylaws are adopted, officers are elected, and other organizational matters are addressed.
- Obtain any required permits and licenses: Depending on the nature of the corporation’s business, it may need to obtain specific permits or licenses before it can begin operating.
- Obtain an Employer Identification Number (EIN): This unique nine-digit IRS number is used to identify the corporation for tax purposes. The EIN can be obtained online through the IRS website.
- Register for state and local taxes: The corporation may need to register for any state and local taxes, such as sales or payroll taxes, depending on its location and the nature of its business.
It’s important to note that the process of forming a corporation can be complex and may require the assistance of a lawyer or other professional. Additionally, ongoing compliance and reporting requirements may vary depending on the state and type of corporation.
S-Corp vs C-Corp: What are the tax differences?
S-Corporations and C-Corporations (or C-Corps) have different tax treatment under the U.S. tax code. Here are some key differences:
- Taxation: C-Corporations are taxed as separate entities, meaning they pay corporate income tax on their profits. If the corporation distributes profits to shareholders as dividends, they must pay personal income tax on the dividends they receive. S-Corporations are pass-through entities, meaning that they do not pay any income tax at the corporate level. Instead, the profits and losses of the business “pass-through” to the shareholders, who report them on their personal tax returns.
- Ownership: C-Corporations can have an unlimited number of shareholders and can issue multiple classes of stock, while S-Corporations are limited to 100 shareholders and can only issue one class of stock.
- Liability: Both S-Corporations and C-Corporations provide limited liability protection to their owners, meaning that the owner’s personal assets are generally protected from the business’s liabilities.
- Fringe Benefits: C-Corporations generally have more flexibility in offering tax-advantaged fringe benefits to employees, such as stock options, health savings accounts, and retirement plans. S-Corporations have more limitations on fringe benefits, such as health insurance for shareholders who own more than 2% of the company.
- Basis and Losses: Shareholders in S-Corporations can deduct their share of losses on their personal tax returns, subject to certain limitations based on their basis in the company. In contrast, C-Corporation shareholders cannot deduct corporate losses on their personal tax returns.
|Limited Fringe Benefits
|Extensive Fringe Benefits
|Requires Reasonable Compensation
|Requires Owner W2
The choice between forming an S-Corporation or a C-Corporation should be based on the specific needs and goals of the business. Other factors to consider include the cost and complexity of formation and ongoing compliance requirements. It’s always a good idea to consult with a tax professional or CPA to determine which type of corporation fits your business best.
How do you elect to be taxed as an S-Corporation?
A company must first meet specific eligibility requirements to elect to be taxed as an S-Corporation. These include:
- Being a domestic corporation
- Having only allowable shareholders, including individuals, certain trusts, and estates, and not having more than 100 shareholders.
- Having only one class of stock
- Not being an ineligible corporation, such as certain financial institutions or insurance companies.
Once a company meets these requirements, it can elect to be taxed as an S-Corporation by filing Form 2553, Election by a Small Business Corporation, with the IRS. This form must be filed two months and 15 days after the beginning of the year that the election is to take effect or at any time during the prior tax year.
It’s important to note that electing to be taxed as an S-Corporation will change how the company is taxed. Instead of the company paying corporate income tax, its income, deductions, and credits flow through to shareholders who report their share of the company’s income or loss on their individual tax returns. This means that S-Corporations are considered pass-through entities for tax purposes.
What is Considered Reasonable Compensation for Corporation Owners?
Determining what is considered a reasonable salary for S corp owners is a complex process. There is no one-size-fits-all answer, as the determination depends on various factors.
The IRS considers several factors when determining whether an S corp owner’s salary is reasonable. These factors include:
- Industry standards: The IRS looks at the average salary for similar positions in the industry to determine what is reasonable.
- Company revenue and profits: The company’s revenue and profits should also be considered when determining an owner’s salary. Owners should consider how much they contribute to the company’s success and factor that into their salary.
- Time and effort: Owners should also consider the amount of time and effort put into the business. If the owner works full-time and contributes significantly to the company’s success, they should receive a higher salary than those who only work part-time.
- Other compensation: Owners should also consider any other compensation they receive from the company, such as bonuses or stock options.
It is important to note that there is no specific formula or percentage for determining a reasonable salary for S corp owners. The determination must be based on the individual circumstances of the business and the owner’s contributions to the company.
The IRS guides reasonable compensation for S corp owners in the form of Revenue Ruling 59-221. This ruling states that the reasonable compensation for an S corp owner is the amount that would be paid to an unrelated party for similar services.
The ruling also states that the following factors should be considered when determining reasonable compensation:
- The employee’s role in the company
- The employee’s responsibilities
- The employee’s time and effort
- The employee’s qualifications
- The employee’s experience
- The complexity of the company’s business operations
- The company’s financial condition
The ruling also notes that the reasonableness of the compensation should be determined when the compensation is paid rather than after the fact. S-Corp vs C-Corp is critical to understand especially for physicians.
Why are S-corporations so popular?
S-Corporations are a popular business structure for several reasons. Here are some of the main reasons why S-Corporations are popular among business owners:
- Pass-Through Taxation: S-Corporations are pass-through entities for tax purposes, which means that the profits and losses of the business “pass-through” the business to the individual shareholders, who report the income on their personal income tax returns. This can result in lower overall tax liability compared to a traditional C-Corporation structure, which is subject to double taxation.
- Limited Liability Protection: Like C-Corporations and Limited Liability Companies (LLCs), S-Corporations provide limited liability protection for their owners. This means that the owner’s personal assets are generally protected from business liabilities and debts.
- Flexibility in Ownership and Management: S-Corporations allow for flexibility in ownership and management. They can have one or more owners (up to 100) and be managed by the owners or a board of directors.
- Ability to Raise Capital: While S-Corporations are limited in the number and type of shareholders they can have, they can still raise capital by selling stock to investors.
- Tax Benefits for Owners: S-Corporation owners who work for the business may reduce their self-employment tax liability by taking a reasonable salary and receiving additional profits as distributions instead of taking all profits as self-employment income. This can result in significant tax savings for owners actively involved in the business.
Overall, S-Corporations offer a balance of liability protection and tax advantages, making them an attractive option for many small business owners. However, it is essential to carefully consider your business’s specific needs and circumstances before choosing a business structure. It is recommended to consult with a tax and legal professional to determine the best structure for your business.