S Corporation vs C Corporation: Everything You Need to Know
S corporation vs C corporation is a common comparison for individuals interested in starting a business. 5 min read
S Corporation vs C Corporation
S corporation vs C corporation is a common comparison for individuals interested in starting a business. One of the first things a business owner needs to do to get their business running is decide what business structure, or business entity, they want to have. There are a number of business entities to choose from, each with its own advantages and disadvantages. Business owners should always consult with professionals, such as a business attorney and an accountant, before coming to a final decision.
One option business owners have is to incorporate. By forming a corporation, a business owner creates a legal entity that is totally legally separate from the individual owners. This is important for personal liability and tax purposes.
Corporations can only be formed by filing Articles of Incorporation with the state government in which the corporation will be headquartered. For most states, this filing must go to the Secretary of State.
Corporations are owned by shareholders that are legally distinct from the corporation itself. Therefore, shareholders are not personally liable for the debts and liabilities of the corporation.
The traditional corporation is called the C corporation. This type of corporation allows for an unlimited number of shareholders, and is ideal for businesses that are planning on growing and are actively seeking more investors. C corporations also offer more flexible stock options and profit sharing structures than other entities. They can also carry losses or profits into following years, which can reduce tax burdens and keep earnings in the business.
Finally, C corporations are ideal for business owners that plan on selling their interest in the business, because stock ownership is fully transferrable.
The primary downside to C-corporations is that they are taxed and shareholders are taxed when they receive dividends. This results in “double taxation” on corporate profits. Because of double taxation, many smaller businesses find the C corporation entity form untenable.
What is an S Corporation
The S corporation is an entity that is able to avoid double taxation. If certain requirements are met, a corporation can file for S corporation status with the IRS. Forming an S corporation also requires a filing of Articles of Incorporation.
S corporations are still a separate legal entity from the shareholders that own it, but the business profits and losses “pass through” the entity and go directly to the shareholders. Therefore, the corporation itself does not pay any taxes, and shareholders instead report corporate profits on their own tax returns.
There are requirements that must be met for a business to qualify as an S corporation, but if these requirements are met, an S corporation has much more flexibility in its internal accounting. Many business owners choose the S corporation because there is a lower chance of an IRS audit than with C corporations. This is because the S corporation must file an information tax return, called Form 1120, which reduces the audit rate for S corporations. C corporations can be converted into S corporations.
Because S corporations are not double taxed, many owners choose this entity to save on taxes. But, any shareholders that are also employees must pay a self-employment tax on the salary they take from the corporation. S corporations, despite having similarities with less complicated LLCs, still have many of the strict requirements of traditional corporations have. Therefore, setting up and maintaining an S corporation isn’t necessarily cheaper than a traditional C corporation.
Similarities between S Corp and C Corp
S corporations and C corporations both offer owners protection from individual liability. They are both separate legal entities and both require a filing of Articles of Incorporation with the state. Both are shareholder owned, have a Board of Directors, and typically are managed by executive officers.
The Board of Directors of a corporation oversees the major decisions and determines the broader strategies of the corporation. The executive officers, who are elected by the Board of Directors, manage the day-to-day affairs.
Both S corporations and C corporations are required to have the same formal filings, annual meetings, and must pay annual fees. Both must have Bylaws, issue stock, and are usually required to have a Board of Directors.
Differences between S Corp and C Corp
The most significant difference between a C corporation and an S corporation is that S corporations are not taxed as separate entities. C corporations must file a corporate tax return and pay taxes at the corporate level. When profits are distributed to shareholders, the shareholders must also pay taxes on those profits on their personal income taxes. S corporations do not pay taxes (although they still must file an income tax return). Corporate profits are taxed when they are distributed to shareholders as personal income.
S corporations cannot be owned by more than 100 individuals, and can only be owned by natural individuals (not by other corporations, LLCs, trust, or any other artificial entities). S corporations can only be owned by United States citizens or resident aliens. C corporations can be owned by any other legal entity, foreign or domestic.
C corporations can have multiple classes of stock and various different profit sharing structures, but S corporations are required to only have one class of stock. Because C corporations are less restricted with regards to stocks, it is usually easier to attract investors and grow a company if it is a C corporation.
What is a Limited Liability Company
A Limited Liability Company (LLC) is a modern alternative to the corporation. An LLC is not incorporated, so the advantages of offering public stock are not available. However, LLCs are much more flexible in how they can be managed, do not take as much time and money to maintain, and still insulate individual owners (“Members”) from personal liability for company losses.
They are also often a good choice for tax purposes as they are, like the S corporation, a “pass through” entity that avoids double taxation. LLCs are by default not taxable entities, and Members pay for LLC profits on their individual tax returns.
LLCs are formed by filing Articles of Organization with the state. There are fewer formal requirements and fees needed to set-up and maintain an LLC than a corporation. However, some states levy additional taxes on LLCs (California for instance has a “franchise tax” that applies to LLCs).
LLCs are preferred by those that want to pass the profits and losses on directly to the owners. They are also more flexible in terms of how they can be managed. There is no requirement that LLCs have a Board of Directors of Bylaws. Some states do require an Operating Agreement, and most LLCs should have an Operating Agreement regardless of whether it is required by law. LLC Members can opt to manage the LLC themselves, or they can hire others to do so for them.
There are fewer formalities with an LLC. Many small business owners prefer them for this reason. There are no annual meetings, Board meetings, or record keeping requirements as with corporations.
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