The ongoing debate between C corporations (C corps) and S corporations (S corps) continues to shape business decisions. Each legal business entity provides different benefits and limitations around taxation, business operations, and ownership structures.
Whether you’re a sole proprietor who decided to incorporate or starting a new business from scratch, you need to think through your business structure from a tax and long-term business operations perspective. If you’ve decided to incorporate, you’ll need to determine your status: C corp vs S corp. The default designation of an incorporated business is a C corporation. If you want S corporation status, you’ll need to file an additional form. The IRS has more information on both business structures.
As you navigate this choice, we’ll breakdown the intricacies of both structures, highlighting their pros, cons, and practical implications.
Ownership & Formation
C Corporation (C corp)
- Default Structure: C corps are the default corporate form. They exist independently from their owners, allowing for perpetual existence.
- Ownership Flexibility: C corps have no restrictions on ownership. They can have multiple classes of stock, making them suitable for complex ownership arrangements.
- Ideal for Larger Companies: If you’re seeking venture capital or planning substantial growth, a C corp provides the necessary flexibility.
S Corporation (S corp)
- Election Process: To become an S corp, you must file IRS Form 2553. This election transforms your corporation into a pass-through entity.
- Limited Shareholders: S corps are limited to 100 shareholders, simplifying ownership structure.
- Tax Advantages: S corps avoid corporate tax rates, as profits and losses flow through to individual shareholders’ tax returns.
C corporations are flexible in terms of ownership; S corporations are not. S corporations have only one class of stock, they must be owned by U.S. citizens or resident aliens, and they can have no more than 100 shareholders.
The Double Taxation Dilemma
C Corporation:
Each corporation type has a direct effect on your taxes and can affect your bottom line. C corps pay corporate income tax (currently 21%) on their profits. Shareholders then pay tax on dividends received.
Example: Megan operates a one-person design business that’s incorporated as a C corporation. If she makes $100,000 under the current regulations, her corporation will pay $21,000 in income tax. If Megan takes the rest as a dividend, it’s taxed at the dividend rate of 15% — creating a total tax bill of just over $32,000.
S Corporation:
When you file for an S corporation election by filing form 2553, you create what’s known as a passthrough entity. With a passthrough entity, individuals report their share of the corporation’s income on their personal income tax returns via form 1120-S. Currently, many S corporations are eligible for the IRS’s qualified business income deduction, which means that 20% of their profits aren’t taxed.
Example: Lakeisha operates a one-person design business that’s incorporated as an S corporation and generates $100,000 in income. Because she works for the corporation, she must pay herself a reasonable salary. After conducting market research and consulting an attorney, she determines her at-market salary to be $50,000, which she pays to herself via a W2 and pays income and employment taxes on through her payroll processor. The remaining $50,000 is distributed as profit, and Lakeisha is exempt from paying self-employment taxes on those dividends. Assuming she takes advantage of the qualified business deduction and pays an income tax rate of 21% on what she generates, her taxes would be approximately $24,500 — saving potentially thousands of dollars in self-employment taxes over a comparable C corporation.
Taxes Don’t Tell the Whole Story
The tax picture for an S corporation might look rosier, but there are other benefits at play. For instance, C corporations can deduct charitable contributions and offer benefits that aren’t taxed, so long as 70% of the corporation’s employees receive those benefits.
S-Corp owners can take advantage of the qualified business income deduction, allowing them to deduct 20% of net revenue. Individual losses can also be written off on an owner’s tax return. Imagine that Megan and Lakeisha each take a loss in their first year of business, but they’re also working another W2 job. Megan’s losses will carry forward and apply to future income from her C corporation, but Lakeisha might be able to deduct her losses against income earned from her other job, her investments and other areas in the year that the loss was accrued. Each situation is different, so consult a tax attorney or a certified public accountant with any questions.
Reasonable Salary Test
S corporations face the extra challenge of proving that the salary they pay their owners is reasonable. If your state tax authority or the IRS thinks that you’re not paying yourself enough to avoid self-employment tax, you could find yourself wrapped up in an audit.
When setting your salary, it’s important to look at your experience and education, what you do for the business, workload, and industry standards. Consider consulting a professional.
Raising Money
Your entity choice is important if you plan to raise money through angel investors or venture capitalists to grow your business. The rules on S corporations are much more restrictive — they can’t have foreign owners, and they can’t have more than 100 shareholders. If you think you’ll need to raise money to grow your business, a C corporation might be a better choice.
The Final Decision: C Corporation vs S Corporation
Weighing the C corporation vs S corporation decision can be tough. Both entities offer many of the same benefits, and their requirements are also very similar. Each entity type comes with tax-filing requirements and provides limited liability protection, meaning that your personal assets may be protected if you’re sued.
Ultimately, you need to understand the implications of your chosen entity on your business as a whole. Seek advice from a tax attorney or certified public accountant to weigh the pros and cons based on your unique business and tax situation. If cash flow is a concern, consider a small business loan to access professional services.
Remember, your incorporation status has long-term consequences for your business. Spend the time to settle the C corp vs S corp debate and figure out which aligns best with your business goals.
