APRIL 20, 2023
C Corp vs S Corp: Best Options for Small Business Owners
The main difference between an S corporation and C corporations is that a pass-through entity can remove double taxation on shareholders. By choosing your business structure and corporation status wisely you adjust how you pay taxes to the Internal Revenue Service.
Corporations
Corporations are commercial entities created through Articles of Incorporation, according to specific state laws. Each corporation is owned by its shareholders. The corporation and its shareholders are considered separate legal entities, thus, responsibility is also separated between the two. As compared to other types of legal entities, a corporation has to follow a different set of requirements and procedures.
To be more specific, shareholders are not responsible for the corporation’s debts liability extends to the measure of their investment in the respective company. They do, however, still have to file their own personal tax returns.
Types
Not all corporations are created the same. They divide into several types, according to tax classifications and requirements. Thus, there are differences between the C-corp, the S-corp, and the LLCs (limited liability companies). The default setup of a company is C-corp, and in this case, the taxation is standard.
To become an S-corp corporation you have to make a specific request. The LLCs are slightly different, as they are taxed as companies with a sole owner, or as commercial partnerships between companies. However, LLCs can also choose between C-corp and S-corp taxation.
C-Corps
This is the most common taxation status for a legal entity. The name comes from the name of the subchapter that defines this corporation type in the Internal Revenue Code. The only difference between a C type and an S type is the taxation category and terms.
The first taxation is applied to the C-corp, according to Form No. 1120, requested by the IRS. Then, the second taxation is applied to the shareholders at an individual level for all their revenues from annual or periodical dividends or for gains coming from selling stock.
The system is known as double taxation, as the taxation is applied for the same gains, first at the corporation level and then, at the individual shareholder level. Shareholders in this type of corporation are not legally allowed to write off business losses through their income statements.
The advantage of founding a C-corporation is that there are no limitations regarding the number and type of shareholders. C-corps can have all sorts of owners, from individuals to businesses and all legal entities registered in the US or abroad. All shareholders of a C-corp have protection for full liability.
S-Corps
This type of corporation has so many similarities with the previous type. The name also comes from the respective subchapter within the Internal Revenue Corp. The difference comes with the taxation category.
The S-corporations are characterized by pass-through taxation. They are exempted from paying a classical federal corporate income tax, thus being exempted from double taxation. The corporate income tax is nevertheless applied to the number of individual shareholders’ gains from dividends.
This means that under specific circumstances and criteria, the shareholder can offset corporate debt from other sources. S-corps is still considered a separate legal entity from its shareholders and benefits from corporate-specific protection against liability.
S-corp ownership is restricted to citizens and permanent residents of the United States, along with some domestic trusts, estates, and tax-exempt organizations. They also cannot exceed more than 100 shareholders, which means they are further disqualified from going public.
Compare
The decision for choosing a C-corp or S-corp taxation depends on each company’s needs. However, in many instances, the S-corp offers business entities more pros than cons. This applies when the personal income tax rate, exemptions, and deductions are lower via a pass-through type corporation, instead of double taxation.
It is also applicable for the corporate losses that once deducted from the personal income taxes will result in a tax saving. Following the
Tax Cuts and Jobs Act of 2017, the S-corps received a special deduction of 20% for the pass-through taxation, along with other benefits.
Formation
The first state is to draft and file the Articles of Incorporation with the corporation bureau of a specific state and under the supervision and approval of the respective secretary of state. You will automatically create a C-corporation. Yet, if you want to get under the S-corp taxation, you have to fill in and then file a Form 2553 from the IRS, which is known as the Election by a Small Business Corporation.
If you are applying for S income taxation from the position of an LLC or a limited liability partnership, before filling out an IRS Form No. 2553, you first have to fill in and file Form 8832, called, Entity Classification Election which allows you to be taxed just like any C-corporation. Both forms must be agreed upon and signed by every one of the business’s shareholders.
If you request S-corp taxation coming with the status of a qualified joint venture, a general partnership, or a DBA (a sole owner operating under the “doing business as” status) the first step is creating a legal business entity, then following the aforementioned steps.
Structure
In many ways both C-corps and S-corps are similar. Its structure includes directors, officers, and shareholders. The corporation is the legal entity owning the whole business. The shareholders are4 the owners of the corporation, and a separate legal entity.
The board of directors is elected by the shareholders who supervise and decides all corporation’s affairs and make all decisions. However, the board of directors is not responsible for daily corporate affairs. The officers are elected by the board of directors and they are in charge of managing day-to-day corporate affairs.
Formalities
All corporations, either C-corp or S-corp are required to follow the same corporate formalities and commercial obligations. This applies to external and internal ones.
Among them are stock issuance, bylaws adoption, organizing meetings for shareholders and directors, annual reports drafting, annual corporation payments, and ensuring a registered office and a registered agent.
Taxes
When can you decide the federal income tax regime best suited for your corporation? The first opportunity is right at the incorporation time. As soon as you create your default C-corporation, you can decide to request the S-corp status.
However, this doesn’t limit you from continuing with the same status for life. You can change your mind later on, depending on the new circumstance, the new taxation laws, etc. that create new realities and needs for your company. So you can apply for a change of status at any time, from C to S or S to C. It is always advisable to take this important decision after consulting with your business and financial tax advisors.
The special 20% deduction for pass-through entities introduced in the 2017 Tax Cuts and Jobs Act favors S Corporations who qualify for it, while the reduced corporation tax rate greatly benefited C corporations.
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