S Corp vs C Corp Tax Advantages: Everything You Need to Know
To better understand S corp vs C corp tax advantages, it's important to understand the differences between the two types of corporations in relation to taxation.4 min read
To better understand S corp vs C corp tax advantages, it's important to understand the differences between the two types of corporations in relation to taxation. A C corporation is a taxpaying entity that is separate from its owners, while an S corporation is known as a pass-through tax entity. Understanding the tax and nontax ramifications is a top priority when determining the structure of a business.
What Are the Differences between a C Corporation and an S Corporation?
When people think about corporations, they typically think of a C corporation. C corporations are the default type of formation when incorporating. Unless you elect S corporation status, you have a C corporation, which is the most common type of corporation in the United States.
In C corporations, the business owners are individual shareholders and it's considered a separate legal entity. They have special liability protections and therefore individual shareholders are typically shielded from personal liability for business debts or lawsuits.
To form a corporation, you still have to file a variety of paperwork with your respective state government, including Articles of Incorporation. Once the business is active, there are compliance obligations and document requirements that must be met, which can include stock issuance, paying fees, and holding director and shareholder meetings.
How to File a C Corporation
Here is how to file a C corporation:
- Choose the business's name and file it with the respective secretary of state office.
- File the Articles of Incorporation and pay the applicable fee.
- Draft corporate bylaws and hold your board of directors meeting. Once the Secretary of State office confirms your Articles of Incorporation, the next step is to issue stock certificates to the initial shareholders.
- Apply for pertinent business licenses and any necessary permits required.
- Obtain your Employer Identification Number (EIN) through the IRS.
- Check with state and local government offices to verify whether you need any other permits or ID numbers.
What to Know About S Corporation Structure
An S corporation is primarily the same as a C corporation, with shareholders, a board of directors, and executive officers. Like the C corporation, an S corporation also has some liability protection that protects owners from personal liability and corporate debts. Also, S corporations are required to file Articles of Incorporation, issue stock, hold meetings, and pay applicable fees.
There are some differences though. S corporations are allowed only 100 shareholders max, and the shareholders can only be U.S. citizens. Essentially, an S corporation is primarily just a tax election rather than a different corporation set up.
To set up an S corporation, you complete the same steps as the C corporation, but you also have to file IRS Form 2533 within 75 days of forming the corporation. Although forming an S corporation is only one additional step, maintaining its status requires diligence. If you mess up the requirements, you may lose your S status and go back to a C corporation.
It's important to note that some states don't recognize the "S" corporation for tax purposes. Be sure to check your particular state to see whether it recognizes S corporation status before you make a decision on your corporation's status. The main reason to elect S corporation status is for the pass-through tax benefits whereas C corporations pay taxes on corporate income.
Possible Advantages and Disadvantages of Each
There are some advantages to operating as an S corporation vs a C corporation:
- One level of taxation as the S corporation doesn't pay taxes on the income, only the shareholders pay the taxes.
- Losses can be deducted from shareholders' individual tax returns whereas income losses in a C corporation are only offset at the corporate level.
- S corporations offer an advantage to split income between family members.
While there are some tax benefits to S corporation status, there are also some disadvantages as well:
- An exclusion for up to 50 percent of gains on "qualified small business stock" is not applicable to S corporations.
- Shareholders of C corporations have greater tax-free fringe benefits.
- Stock in S corporations can only be transferred to very specific and eligible shareholders and it cannot have more than 100 shareholders. This also restricts the ability to raise more capital.
- Estate planning can be more complicated.
- Tax rates are typically higher for individuals versus the rates that would apply to C corporations.
Both types of corporations require personal income tax to be paid on any salary received as well as dividends.
If there are no plans to distribute all profits, forming a C corporation might be better since you can take advantage of "income splitting. "This is where the business income is split in such a way that part of it is taxed at the corporate level and part of it then taxed to the individual owners. This puts them in a lower tax bracket rather than either one being in a higher tax bracket if they had earned all the income.
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