When starting a new business, entrepreneurs often get confused about how they should structure the company. Should it be a C or S corporation? What’s the difference?
In our previous post on drafting buy-sell agreements, we mentioned corporate structure was an important decision that could significantly impact your tax burden. Here are the key differences between an S corp and a C corp to help you make that decision.
What is a C Corporation?
When a small business incorporates, it creates a distinct legal entity that is separate from its owners, who would then be called shareholders. As opposed to a partnership or sole proprietorship, this structure limits each shareholder’s personal liability for any business debts. They would be liable only for the amount invested, and their personal assets would not be on the line.
The process of incorporating automatically creates a C corporation unless otherwise specified.
- If you don’t plan on distributing all your business profits, forming a C corp might be the way to go, says Oblivious Investor finance author and CPA Mike Piper. You can split your business’s income between your corporation and its owners in order to put each into lower tax brackets. Called “income splitting,” this will lower your overall tax burden compared to if your business or its owners were earning all the income.
- You can have multiple classes of stock. Thus, you can ensure major decision making is limited only to those with a certain class of stock.
- There is no limit to the number of shareholders you can have, and non-US citizens or residents can buy shares.
- If you do distribute profits, they are subject to double taxation. Once for the corporation and again for the shareholders.
What is an S Corporation?
An S corp has the same formation requirements as a C corp, but it elects a specific IRS tax status that eliminates the double taxation that can occur on business income.
- Known as “pass-through” tax entities, an S corp pays no tax at the corporate level. Company profits or losses pass-through to shareholders, who will then report them on their individual tax forms.
- Before distributing profits, the law requires S corps to pay owner-employees “reasonable salaries.” These are subject to Social Security and Medicare taxes, making any potential tax savings worthwhile only if your business has a large income.
- You can have only one class of stock.
- You can have only up to 100 shareholders, and non-US citizens or residents cannot buy shares.
Why you might choose an S corp over a C corp
- You want to take advantage of pass-through taxation and avoid double taxation on income and sale proceeds.
- You want to claim any potential business losses personally on your taxes.
Why you might choose C corp over S corp
- You want the flexibility of different classes of stock and profit-sharing among owners.
- You want income to stay with the business to that it can expand.
- You want the flexibility to split your income between the company and its shareholders to minimize tax burdens.
Hopefully this gives you a better idea of whether you want to incorporate as an S corp or C corp. Contact an UpCounsel business formation attorney to help you structure your corporation to meet your business needs.