The C corporation vs S corporation debate rears its head again. Each legal business entity provides different benefits and limitations around taxation, business operations and ownership structures. How do you know which is right for your business?
Whether you’re a sole proprietor who decided to incorporate or you’re starting a new business from scratch, you need to think through your business structure from a tax perspective and a 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.
Let’s take a closer look at what each corporation type means for small business owners and how to select the right structure for your business needs.
Double Taxation for C Corporations
Each corporation type has a direct effect on your taxes and can affect your bottom line. C corporations are subject to what’s often described as double taxation. C corporations pay taxes of 21% on their income when they file form 1020. Owners then pay tax on the dividends they receive.
Let’s look at an example: Small business owner 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.
Passthrough Taxes for S Corporations
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.
For another 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.
And, again, many S corporation owners can claim the qualified business income deduction, meaning 20% of net revenue can be deducted to reduce their overall tax burden. Individual losses can also be written off of 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.
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.
Lakeisha plans to continue as an independent small business owner and doesn’t plan to raise funds or bring in partners, so an S corporation works well for her long-term plan. Megan has considered bringing in a partner, who’s based in Europe, to expand her design business. Because S corporations forbid foreign stakeholders, a C corporation is a better fit for her business.
Reasonable Salary Test
S corporations have the added burden 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, how much you work, and how comparable businesses pay their workers. Consider consulting a professional.
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. One is compliance: Each entity type comes with tax-filing requirements and other annual documentation. Each entity offers owners 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. The advice of a certified public accountant or tax attorney can help you understand the pros and cons of each through the lens of your unique business and tax situation. If you’re hesitant to make the investment or if you’re struggling with cash flow, a small business loan could help you access the professional services you need to thrive.
Your incorporation status can have long-term consequences on your business. Spend the time to settle the C corp vs S corp debate and figure out which will deliver the best solutions for your business today and tomorrow.