What Is the Difference Between S Corp and C Corp?

S corp vs. C corp

Embarking on a new business venture or expanding an existing one is an exciting journey filled with possibilities. A critical aspect of this journey is selecting the appropriate business structure, as it can significantly impact taxation, legal protection, and growth potential. S corp vs. C corp are two types of corporations that offer unique benefits and limitations.

Choosing to incorporate can be a good alternative to forming a limited liability company for a small business. But what is the difference between an S corp and a C corp? Let's explore the similarities and differences between these corporate structures to help you make an informed decision for your business success.

Key takeaways

• Comparing S corporation and C corporation business structures enables business owners to make informed decisions on the best corporate structure for their company.
• S corporations offer pass-through taxation, asset protection, and ownership restrictions. C corporations provide multiple classes of stock options and employee benefits with potential tax deductions but are subject to double taxation on corporate income.
• When selecting between S corp vs. C corp business structures, an entrepreneur should consider the size and goals of the business, tax implications, available ownership, and fundraising options.

Understanding S corporations and C corporations

S corporations and C corporations as business entities are two distinct types of corporate structures, both of which are regulated under the Internal Revenue Code. While an S corp vs. a C corp share some similarities, such as limited liability protection and corporate governance, their differences in taxation, ownership restrictions, stock options, and employee benefits set them apart from one another.

Grasping the subtleties of these structures enables you to develop a more accurate assessment of which option aligns best with your business size, goals, and tax preferences.

Defining S corporations

An S corporation is a business entity that elects to pass taxable income, losses, deductions, and credits through to its shareholders' personal tax returns, making it different from a C corp in terms of taxation. By transferring all business income, losses, deductions, and credits through to shareholders for federal income tax purposes, S corporations avoid double taxation on corporate income. To become an S corporation, businesses must file Form 2553 with the Internal Revenue Service after filing their articles of incorporation with the relevant state.

A significant advantage of this type of entity is its pass-through taxation, providing tax benefits for small businesses. Because they are set up as pass-through entities, shareholders of this type of corporation report the corporation's income, credits, deductions, and losses on their own individual tax returns, thus avoiding being taxed twice and potentially lowering their personal income tax liability. S corporation status may be a suitable choice for a small business that meets specific qualifications, such as having limited numbers of shareholders and adhering to the restrictions on shareholder eligibility.

Defining C corporations

C corporations, on the other hand, are independent legal entities that are owned by their shareholders, possessing unlimited growth potential and being subject to limited liability company double taxation, which is a key difference when comparing a C corp vs. S corp. To form C corporations, businesses must:

• Register with a unique name
• Appoint corporate officers
• File articles of incorporation
• Draft bylaws
• Issue stock certificates
• Acquire pertinent local business licenses as needed
• Submit IRS Form SS-4

C corporations differ significantly from S corporations in that they are subject to double taxation. This means that the income earned is taxed not only at the corporate level but also at the shareholder level. This means that the corporation pays taxes on its profits at the corporate level, while shareholders pay federal taxes on dividends they receive from the corporation at the individual level. However, C corporations offer more flexibility in terms of ownership and stock options, as they can issue multiple classes of stock and have no restrictions on how many shareholders there are.

Key similarities between S corporations and C corporations

 

Although S and C corporation business entities differ in several aspects, they share key similarities when it comes to liability protection, corporate governance, and legal requirements. Both structures shield the owners' personal assets from corporate debts and liabilities, ensuring that the shareholders are not personally or financially responsible for the business' expenses and obligations. Additionally, corporate governance in both structures involves shareholders electing directors, who subsequently appoint officers to manage and run the business on a day-to-day basis.

Finally, both S and C corporation business entities must adhere to legal requirements, such as filing articles of incorporation, holding annual meetings, and filing reports, to legally maintain their corp status.

Limited liability protection

Limited liability protection is a crucial aspect of both S and C corporations (just as it is with a limited liability company), as it safeguards the owners' personal assets from the claims of business creditors. In other words, shareholders of corporations are not personally financially liable for corporate debts, and their personal assets cannot be used by creditors to satisfy the business' debts. This protection ensures that the owners and shareholders are not held personally fiscally responsible for the business's debts and liabilities, allowing them to invest and grow their business with confidence.

Corporate governance

Corporate governance in both S corps and C corps involves a formal structure for managing and overseeing the company's operations. Corporate governance typically includes:

• A board of directors that is responsible for making major decisions and setting the strategic direction of the company
• Officers, such as the CEO, COO, and CFO, tasked with day-to-day operations and management
• Shareholders who have ownership in the company and may have voting rights and receive dividends.

Both types of corporations are mandated to comply with state and federal regulations, file annual reports, and pay fees and taxes.

Legal requirements

Both C and S corporations are subject to specific legal requirements in order to maintain their corporate status. For example, S corporations must file with the Internal Revenue Service to obtain S corporation status and adhere to a maximum of 100 shareholders. On the other hand, C corps have similar requirements but without limitations on the number of shareholders.

Both an S corp and a C corp must file articles of incorporation, hold annual meetings, file reports, and pay taxes as part of their legal obligations.

Differences between S corporations and C corporations

Important differences between C and S corporations include their formation, taxation, ownership, stock practices, and employee benefits. You can decide on the type of corporation that is right for you by learning about the differences between these models. Keep the following factors in mind when deciding between the two types of corporations.

Formation

In the eyes of the IRS, all corporations automatically begin as C corporations when they are formed. A C corporation may convert to an S corp by filing IRS Form 2553, Election by a Small Business Corporation, with the IRS if it so chooses. There may also be state forms to file to obtain S corp status for state tax purposes. This then legally changes the company from a C to an S corp.

S corporations get their name from provisions in the law that permit this type of legal entity in Subchapter S of Chapter 1 of the Internal Revenue Code.

To obtain S corp status for a certain year, you must file Form 2553 by March 15 of that calendar year for corporations operating on a calendar-year basis. Corporations operating on an alternative fiscal year (and who have business reasons for doing so) can file no later than the 15th day of the third month of the fiscal year.

Taxation

The main reason for choosing an S corp is to save on taxes. It is important to understand the different tax statuses of these corporations.

• C corporation profits incur taxes that are reported on the corporation's own tax return. Any after-tax profits are then distributed to shareholders as dividends and face taxes again. Shareholders report this income on their personal tax returns. You can avoid being taxed twice by electing S corp status for your corporation. C corporations file taxes on Form 1120.
• S corporations file taxes like a sole proprietorship or a partnership does. The profits (or losses) of the business pass through an S corp to the shareholders, who pay taxes and report them on their personal tax returns. S corporations file on Form 1120-S.

Many states also pass profits and losses through to the owners of S corporations. However, a few states unfortunately engage in double taxation of S corporations. This is a key factor to take into account as a business owner when deciding where you want to incorporate.

Ownership

A C corporation will provide more flexibility in selling stock shares than an S corp. According to the IRS, a corporation that elects S corp status may not:

• Have more than 100 shareholders
• Issue more than one class of stock
• Have shareholders who are not U.S. citizens or residents
• Be owned by a C corporation, other S corporations, limited liability companies (LLCs), partnerships, or various trusts

None of these restrictions apply to C corporations, which can help that type of company grow larger. For example, having more than one class of stock can help a small business raise capital from investors for growth without giving them voting rights.

Stocks and shares

C corporations are more likely to appeal to investors. This is because they place minimal limits on shareholders and issue multiple types of stock. Because of their tax status, S corporations face more restrictions. As a result, they must:

• Limit their number of shareholders to 100 or less
• Only issue one class of stock (which may or may not include voting rights)
• Restrict ownership to U.S. citizens

Additional benefits

Any company may choose to provide benefits to its shareholders, who are also its employees, such as health, life, and disability insurance. C corps can deduct the cost of such benefits, and they won't be taxable to the shareholder—as long as the benefits extend to at least 70% of the employees.

An S corp cannot deduct the cost of the benefits, and benefits that are offered are taxable to any shareholder who owns more than 2% of the company's stock.

Crucial differences between S corporations and C corporations

While S corps and C corps share some similarities, their key differences have to do with tax status, ownership restrictions, stock options, and employee benefits and set them apart. Understanding these distinctions is crucial for business owners of small businesses when choosing the most suitable structure for their company and creating their business plan.

The upcoming sections provide a detailed examination of these differences, assisting business owners in making a well-versed decision.

Taxation

One of the most significant differences between S corps and C corps is how they are taxed under the Internal Revenue Code. S corporations have the tax advantages of taxation that passes through, meaning that the corporation's income, losses, deductions, and credits are passed through to its shareholders, who then report them on their individual tax returns. This structure allows them to have the maximum personal tax rate and avoid double taxation, as the corporation itself does not incur federal income tax.

Conversely, C corporations are subject to double taxation, as they are pass-through entities taxed at the corporate level through corporate income tax and then again at the individual level when shareholders receive dividends. This means that C corporations pay a flat rate of 21% on their corporate income taxes, and shareholders pay individual income taxes on dividends they receive from the corporation. The choice between taxation that passes through and double taxation can significantly impact the overall tax liability of a business and its shareholders, so it is a key point to evaluate carefully.

Ownership restrictions

S corporations face more stringent ownership restrictions than C corporations because of the benefits associated with them. Some of these restrictions include the following:

• A maximum of 100 shareholders
• A requirement that all shareholders must be U.S. citizens or residents
• Certain entities, such as other corporations and non-resident foreigners, are not eligible to own shares in an S corporation

On the other hand, C corporations have no restrictions on ownership, allowing for more flexibility in terms of investors and stockholders.

Stock options

Another difference between S corps and C corps is in their stock options. S corporations are restricted to having only one stock class, ensuring that all shareholders have equal rights to distributions and liquidation proceeds. This limitation can impact the corporation's ability to raise capital and attract investors because all owners are treated exactly the same.

In contrast, C corporations are able to issue multiple classes of stock, providing more flexibility in terms of ownership, control, and voting rights. This flexibility can be advantageous for businesses seeking to scale and expand and makes them more appealing to investors.

Employee benefits

Employee benefits also vary between an S corp vs. a C corp. S corporations are subject to restrictions on allowable benefits, such as high deductible health insurance premiums, wellness or preventive care, and health stipends for S corp shareholders. In comparison, C corporations are able to offer a wider range of employee benefits, including tax deductions and tax-free fringe benefits for both the corporation and its shareholders or employees.

These benefits can include health insurance, retirement plans, and other perks that are fully deductible for the corporation.

Pros and cons of S corporations

S corps offer certain advantages and disadvantages that small business owners should consider when evaluating and choosing a corporate structure. Understanding the distinct aspects of S corps, such as their pass-through taxation and ownership restrictions, helps entrepreneurs decide if this structure aligns with their business goals and objectives.

Advantages of S corporations

As previously mentioned, S corps' business structure offers tax advantages for a business owner through their pass-through taxation system, which is useful for small businesses. This structure allows the shareholders to report the corporation's income, losses, deductions, and credits on their individual tax returns, potentially lowering their personal income tax rate and liability. Furthermore, S corps can provide asset protection to their shareholders by shielding the shareholder's personal property from potential lawsuits or debt collections directed at the S corps.

Another advantage of S corps as business structures is the streamlined process of transferring ownership shares. S corporation stock is generally transferable, provided that the IRS ownership restrictions are observed, making the process of changing ownership more straightforward than in other business structures. This ease of ownership transfer can be particularly beneficial for small businesses looking to expand and acquire new owners.

Disadvantages of S corporations

Despite their advantages, S corps also have certain disadvantages that business owners should consider when setting up their company. One notable downside is the ownership restrictions, which limit the number of shareholders to a maximum of 100 and require all shareholders to be U.S. citizens or residents. Additionally, certain entities, such as other corporations and non-resident foreigners, are not eligible to own shares in an S corporation at all.

S corps are also limited in terms of stock options and deductible employee benefits. As previously discussed, S corporations are restricted to having only one class of stock, and they face limitations on deductible benefits, such as high deductible health insurance premiums, wellness or preventive care, and health stipends for S corp shareholders. These limitations may impact the corporation's ability to raise capital, attract investors, and offer competitive employee benefits.

Key takeaways

• Unlimited shareholders: Unlike S corporations, C corporations allow for unlimited shareholders
• Attractive to investors: Buying into a C corporation is straightforward and a wise investment thanks to its well-defined structure
• Access to net operating losses: C corporations facing losses one year can deduct them from future years' profits, providing tax benefits
• Large and complex structure: C corporations can grow to massive sizes, requiring high labor costs and capable and specialized management
• Double taxation: C corp earnings face both corporate income tax and personal income taxes
• No personal write-offs: Investors can't write off business losses under the tax code on their individual income taxes with C corporations

Pros and cons of C corporations

C corps also have pros and cons that should be weighed when deciding on a business structure. Understanding the distinct advantages and drawbacks of C corps, including their ownership flexibility and stock options, along with their two levels of taxation, helps entrepreneurs decide if this structure suits their business.

Advantages of C corporations

C corporations offer more flexibility in ownership, as they can be owned by an unlimited number of shareholders and have no restrictions on the type of entities that can own shares. This flexibility allows C corps to attract a broader range of investors and raise more capital for the business. Additionally, C corporations can issue multiple classes of stock, providing more options in terms of ownership, control, and voting rights.

Another advantage of C corporations is their ability to offer a wide range of employee benefits. As mentioned earlier, C corps can provide tax deductions and tax-free fringe benefits for both the corporation and its shareholders or employees, including health insurance, retirement plans, and other perks that are fully deductible for the corporation. These benefits can help attract and retain top talent, giving C corps a competitive edge in the marketplace.

Disadvantages of C corporations

One significant drawback of C Corporations is double taxation. As previously discussed, they are taxed on their corporate income profits at the corporate level, while shareholders pay taxes on dividends. They receive qualified business income or from the corporation at the individual level. This double taxation can result in higher overall tax liabilities for both the corporation and its shareholders.

Additionally, C corporations may face higher administrative costs compared to other business structures, such as S corporations or limited liability companies. This is due to the more stringent management requirements, including the need for a board of directors and distinct management entities. Moreover, the cost of establishing a C corporation is typically higher than that of incorporating an S corporation.

Key takeaways

• Pass-through tax benefits: An S corporation has tax advantages in that it does not pay corporate taxes at the federal level.
• Employee income: S corporation shareholders can work as employees of the corporation and receive a salary.
• Simple transfer of ownership: Shareholders can transfer their interest in an S corporation without tax consequences.
• Cash accounting: C corporations must use the accrual accounting method unless they fit the "small corporations" criteria and meet the IRS's gross receipts test. S corporations can use the more simplified cash accounting method unless they have inventory.
• No accumulated earnings tax: S corporations don't pay the accumulated earnings tax, which C corporations do when they earn excessive income without paying a portion to shareholders.
• Single taxation level on business sales: When owners sell an S corporation, they are taxed on the distribution. With C corporations, the corporation pays taxes first, and shareholders pay taxes again once they receive their proceeds.
• Lower cash reserves: S corporations build cash reserves slowly because shareholders need distributions to file personal income taxes.
• Taxes on benefits: Most corporate benefits are taxable as compensation to employee shareholders who own more than 2% of the S corp.
• Stock restrictions: S corporations can only have 100 shareholders and only one class of stock, although they can issue both voting and non-voting shares
• Income and loss allocation: Because of their stock restrictions, S corporations cannot allocate losses or income to particular shareholders.
• IRS scrutiny: The IRS scrutinizes S corp payments to ensure they reflect dividends and salaries accurately.
• Accidental termination: S corporations lose their tax status when shareholders transfer interest to restricted parties, such as a nonresident alien.

Choosing between an S corp and a C corp

When choosing between an S corp and a C corp business structure, factors such as the business's size and objectives, the tax implications, and the available ownership and fundraising options should be taken into account. Each structure has its unique advantages and disadvantages, and the ideal choice will depend on the specific needs and goals of the entrepreneur.

Assessing business size and goals

Business size and goals play a crucial role in determining the appropriate corporate structure for your company. Generally, smaller businesses may prefer to set up as an S corp due to its pass-through taxation and ease of use, while larger businesses with plans for significant expansion and potential access to external investors may opt for a C corp structure to take advantage of its flexibility and capacity to issue different classes of stock.

Evaluating tax implications

Considering tax implications is an essential part of choosing between an S corp and a C corp business structure. S corps offer pass-through taxation, potentially lowering shareholders' personal income tax rates and liability, while C corps face double taxation of corporate income at both the corporate and individual levels.

When it comes to managing their finances, business owners should carefully evaluate the various income tax consequences of each type of structure in relation to their specific financial situation and objectives, including the need to pay personal income taxes and file personal tax returns, as this can greatly impact their overall financial health.

Weighing ownership and fundraising options

Ownership and fundraising options also impact the choice between S corps and C corps. S corps are limited in terms of ownership and stock options, which can affect their ability to raise capital and attract investors. On the other hand, C corps offer more flexibility in ownership and stock options, allowing them to draw from a wider base of investors and raise more funds for the business.

Business owners should weigh these factors against their growth plans, goals, and fundraising needs to determine the best corporate structure for their company.

Generally, an S corp is more popular with smaller businesses because of the potential tax savings and a C corp is more popular with larger companies because of the corporate tax rate and the greater flexibility to raise capital. However, whether an S corp vs. a C corp would be best for your business depends on a careful analysis of the various factors related to your particular situation.

You'll get closer to your ideal structure by asking yourself these key questions:

Would you accept an acquisition?

Buying out a C corporation is easier than acquiring an S corporation. C corporations face minimal restrictions on who can buy shares and when. On the other hand, S corps allow for fewer shareholders, and investors must pay taxes on the income from their shares. As a result, C corporations appeal more to investors.

Do you want to limit shareholders?

S corporations can only have 100 shareholders at a time. Additionally, S corp owners and investors tend to be more involved in operations than C corp shareholders are. While this type of structure consolidates control, they are harder to buy into and are less appealing to investors.

Can you handle IRS scrutiny?

Because of their tax arrangement, the IRS keeps closer tabs on S corporations. Avoiding mistakes and errors that could lead to audits takes priority here. You must also file additional forms to change the classification from a C corp in compliance with the Internal Revenue Code.

Making a choice

Choosing the right corporate structure for your company is a critical decision for any business, as it can significantly impact taxation, legal protection, growth potential, and more. Both S corps and C corps have their own unique advantages and disadvantages, and the ideal choice will depend on the specific needs and goals of the entrepreneur. By carefully assessing business size and objectives, evaluating tax implications, and weighing ownership and fundraising options, business owners can make an informed decision that sets their company up for long-term success.

Frequently asked questions

Is it better to be an S corp or a C corp?

Overall, an S corp is better for smaller companies looking to save on taxes and reduce the burden of double taxation for corporate income. On the other hand, C corps may offer more flexibility in terms of shareholders and are more attractive to investors due to their single layer of taxation. The path that is best for you depends on you goals and vision for your company.

Can an S corp own 100% of a C corp?

Yes, an S corporation can own up to 80% of a C corporation, and the two companies may join in filing a consolidated return.

What entities can own an S corp?

An S corp can be owned by individuals who are U.S. citizens or permanent residents and certain trusts and estates, but not by business entities such as C corporations and partnerships.

What is the difference between an S corp and an incorporation?

One of the primary differences is that  C corporations are taxed at the corporate level with double taxation, while S corporations file IRS Form 1120S, and profits, losses, deductions, and credits pass through the entity level without corporate taxes.

Can C corporations issue multiple classes of stock?

Yes, C corporations are able to issue multiple classes of stock, giving them the ability to distribute ownership, control, and voting rights as desired and providing flexibility of ownership.