What is an S-Corp vs C-Corp?

by Adarsh Raj Bhatt in
aerial view of city buildings during daytime

Image credit: Unsplash

Key Takeaways

  • According to IRS legislation, the C-corporation is the common (or default) corporation. Because of its simplicity, it could be a good choice for a startup, especially if you are the sole founder. C-corps are more attractive to potential investors for reasons we will discuss below.
  • The S-corporation is a corporation that has a special tax status with the IRS and therefore, enjoys certain tax benefits, such as avoiding double taxation, which can be attractive to a fledgling startup.
  • Founders evaluating S-corporations vs. C-corporations typically base their decision on how they want the startup to be structured for federal income tax purposes.
  • The laws within each state make no distinction between S- corporations and C corporations. However, in order for your startup to be registered as an S-corporation, the Internal Revenue Code imposes certain limitations on who might qualify as a shareholder.
  • The entity type you choose has a significant impact on many facets of your startup, from taxation to funding to growth strategies. Examining the benefits and drawbacks of your options can assist you in making the best decision.

What are S-Corporations? 

Corporations that elect to transfer corporate profits, losses, deductions, and credits to their shareholders for federal tax purposes are known as S-Corporations. S-corporation shareholders report the flow-through of losses and income on their private tax returns and are taxed at their individual income tax rates. This prevents S- corporations from paying double tax on their corporate income. 

S-corporations are taxed at the entity level on certain built-in profits and passive income. To become an S-corporation, the corporation must file Form 2553 Election by a Small Business Corporation which must be signed by all stakeholders.

To be eligible for S-corporation status, a company must meet the following criteria:

  • Be a domestic business
  • Have only eligible shareholders: Individuals, some trusts, and estates are eligible. Partnerships, companies, and non-resident aliens are not eligible shareholders.
  • Have a maximum of 100 shareholders
  • There should only be one class of stock.
  • The entity should not be ineligible (i.e., certain financial institutions or insurance companies).
brown and blue concrete building

What are C-Corporations? 

A C-Corporation is one of the many ways used to legally identify an organization for tax, administrative, and official purposes. A C- Corporation is essentially a corporate structure that differs from other common business structures such as S-Corporations, Limited Liability Companies (LLCs), Sole Proprietorships, and so on.

A C-Corporation structure is usually more suitable for larger businesses. This is especially true if they intend to issue stock to the public via an Initial Public Offering, or an IPO. Since it allows for greater control of the company, a C-Corporation is far more appealing to potential investors, including venture capitalists and shareholders.

While a C-Corp could theoretically be small enough to consist of only one individual, the majority of large-sized companies in the U.S. are structured as C-Corporations. The information below will assist you in determining whether a C-Corporation or an S- Corporation structure is more appropriate for your startup.

How Does an S-Corporation Work? 

To become an S-Corporation, the business must first become a corporation by filing documents such as the Articles of Incorporation or Certificate of Incorporation to the relevant government authority, together with the required fee. 

To be granted the S-Corporation designation, all shareholders must then sign and submit Form 2553 after the incorporation process is completed. Taxes are then dealt with on an individual level by the corporation's shareholders. 

This is among the most enticing aspects of an S-corporation. A standard corporation's taxable income, on the other hand, is taxed twice: first at the corporate level, then at the individual level.

How Does a C-Corporation Work?

When a company is incorporated, a C-corporation (or a regular corporation) is formed automatically. A C-corporation has its own life and a legal nature independent of the company's owners. A C- corporation may amass its own debts and claim all of an individual's rights. After paying taxes on the company's income, C-corporations are entitled to issue dividends to shareholders. Dividends are then charged at the shareholder's rate of personal income tax. 

The executive board, which is also in charge of implementing the company's rules and regulations, makes strategic decisions. The C- corporation's officials, such as the treasurer, manager, and president, are selected by the board of directors. The officials are in charge of monitoring the business's day-to-day operations.

S-Corp or C-Corp for Startups?

 A skilled tax professional will decide which option would offer the greatest tax benefit to your startup. A corporate lawyer can help you navigate the dynamics of ownership and revenue distribution.

When an S-corporation makes sense

S-corporations are ideal for company owners who:

Want to hold profits as income: If the majority of your profits will be distributed, an S-corp will help you avoid double taxation.

Can gain from losses: If you can use your business losses to cover other profits, an S-corp might be right for you.

Have a low personal tax rate: Having a low personal tax rate, combined with the possible QBI deduction and self-employment tax benefits, will result in significant tax savings with an S-corp.

When a C-corporation makes sense

C-corporations are preferable for companies that:

Have international connections: Unlike S-corporations, C- corporations have no restrictions on foreign ownership.

Reinvest profits: C-corporations allow you to accumulate wealth in your startup without having to pay it out as personal income.

Need unrestricted growth potential: C-corps can issue an unlimited number of shares of stock.

Benefits and Limitations of C-Corps and S-Corps

Benefits of S-Corps

#1: Single Tax Layer

An important benefit of having an S-Corp is that you will avoid having your company taxed twice as a business owner. Profits earned by a C-Corp, on the other hand, are taxed first as the corporation, followed by all (dividend) distributions. 

This is something that S-Corps avoid. 

#2: Exemption from Self-Employment Taxes

Another benefit of S-Corps is that dividends are exempt from self-employment taxation, allowing shareholders to greatly reduce their tax burden.

#3: Ability to Transfer Ownership

Another benefit is the ability to transfer ownership. If more than half of a limited liability company (LLC) is transferred, then the company as a whole might be dissolved. An S-Corp shareholder, on the other hand, can sell their shares of the company without it being terminated.

Benefits of a C-Corp

#1: Limited Liability

Liability is limited in a C-Corp. This applies to directors, officers, shareholders, and staff.

#2: Unlimited Growth Potential

Thanks to the selling of stock, the sky's the limit for C-Corps. 

This translates to practically unlimited growth potential. 

#3: No cap on the number of shareholders

A C-Corporation has no cap on the number of shareholders. 

However, the Securities Exchange Act of 1934 requires the corporation to file with the SEC once it has $10 million in assets and 500 shareholders.

#4: Tax benefits

The C-Corp structure allows you to take advantage of company costs that are tax-deductible.

Limitations of S-Corps

#1: Restrictions on stock ownership 

While an S-corporation can have both voting and non-voting shares, it can only have one class of stock. As a result, different classes of investors cannot be given multiple dividends or distribution rights. 

In addition, the number of shareholders is restricted; no more than 100 people may be shareholders. Foreign ownership is forbidden, as is ownership by some categories of trusts and other entities (for example, a non-resident alien cannot be an owner).

#2: IRS scrutiny would be more intense

Since dividends or salary might be distributed to shareholders, the IRS scrutinizes payments to ensure that the characterization is accurate. As a result, salaries can be reclassified as dividends, resulting in a deduction for the business. 

Dividends, on the other hand, may be reclassified as income, rendering the company responsible for employment taxes.

#3: Tax qualification obligations

Mistakes in the various nominations, approval, notifications, stock ownership and filing criteria will result in the S-corporation's status being terminated (by mistake). 

While this is a relatively uncommon occurrence that is normally easily remedied, it is still a problem that does not exist in other business types and is a specific limitation of S-Corps.

Limitations of C-Corps

There are a few drawbacks to C-Corps:

#1: Double Taxation

It's inevitable that income is charged both at the corporate level and at the level of shareholder dividends.

#2: Associated Expenses

There are several costs associated with filing the Articles of Incorporation. S-Corporations, on the other hand, pay fees to the states in which they operate.

#3: Formalities and regulations

Because of complicated tax codes and the immunity given to owners against being held liable for defaults, litigation, and other financial commitments, C-corporations are subject to greater regulatory scrutiny than other types of businesses.

#4: Corporate losses are not deductible

Shareholders, unlike in an S-corporation (S-corp), cannot deduct corporate losses on their personal tax returns.

S-Corp vs. C-Corp Tax Calculator

If you choose for your startup to be charged as an S-Corp, you must pay yourself a wage with a paycheck. Those earnings are liable to self-employment tax, but the residual distribution (the difference between the net income and your salary) is not.

What is your estimated annual business net income? 

This is your taxable net income after deducting all of your business expenses from your income.

What Salary Will You Pay Yourself if You're an S-Corporation? 

You must pay a decent wage in the form of a paycheck. Other than proper pay for services rendered to the corporation, the IRS does not provide a precise description of what a "reasonable salary" is. A reasonable rule of thumb is to pay the "average" salary for the job, with any surplus paid as a distribution or reinvested back into the company. 

Assume you are a photographer in Philadelphia who expects to earn $60,000 in company net profits this year. The average salary for a photographer in Philadelphia is $33,000, according to glassdoor.com. So you can reach $60,000 as your net income and take a salary of $33,000, saving you about $3,429 in taxes.

Check out this S-Corp tax calculator

C-Corporation Tax Calculator has the following major features:

  • Either standard corporate tax or Personal Service Corporation (PSC) rates are used to calculate the tax.
  • It handles capital loss carryforwards to the present year and calculates how much capital loss should carry forward to future years.
  • Section 1231 gains are treated as capital gains, while Section 1231 losses are treated as ordinary losses.
  • It allows for the carrying forward of NOLs (Net Operating Losses).
  • If necessary, it computes the charitable deduction limitation.

C-corporation Tax Calculator

How to Change a C-Corp to S-Corp? 

Since the most major distinction between the two corporate structures is in tax filing status; the only requirements for transitioning from a C-corporation to an S-corporation are: 

  • Complete and file the necessary paperwork with the IRS to adjust the tax election
  • File the proper annual federal tax forms for an S-corporation from that stage forth

Am I an S-Corp or a C-Corp? 

Knowing what type of corporation your company is is critical in some situations, particularly during tax season. A C-corporation must pay tax on its gross revenue, while an S corporation does not. 

Instead, an S-corporation's net income is distributed to its shareholders, and each shareholder pays tax on the startup's profits based on: 

  • Their personal tax rate
  • The portion of the business that they own

It could take only a few minutes to determine your category.

Examine your archives for any IRS correspondence

You must make an election to be treated as an S-corporation in order to actually be listed as such. IRS Form 2553 is used to make an election. Following the IRS's processing of the form, you will receive a letter confirming your election as an S-Corp.

Thus, examining your archives for any IRS correspondence might prove helpful in determining your startup's category.

Examine past tax returns 

Examine past tax returns. Every company is required to file an annual income tax return. S-corporations file Form 1120S, while C- corporations file Form 1120.

Dial 800-829-4933 to reach the IRS Business Assistance Line

Dial 800-829-4933 to reach the IRS Business Assistance Line.

Then, based on any elections you might have made and the type of income tax returns you file, the IRS may check your business file to determine if your startup is a C-corporation, S-corporation, partnership, single-member LLC, or sole proprietor.

Summary: Key Differences Between an S-Corp and a C-Corp 

#1: Taxation

The primary distinction between C- and S-corporations lies in taxation. C-corporations pay taxes on their earnings, and you pay taxes on any profits you receive as a founder. An S-corporation does not have to pay taxes. Instead, you and your co-founders record the company's revenue as personal profits.

#2: Organization

C-Corporations are the most common form of organization. When you submit articles of incorporation in your state, you are known as a C-Corp. 

On the other hand, form 2553 must be filed if you wish for your startup to be recognized as an S-Corporation. There might be additional forms to fill out in order to maintain your status as an S- Corp.

#3: Ownership

When it comes to ownership, C-Corps have practically no limits. Anyone can be an owner and you can have as many shareholders as you want. S-Corps, in contrast, are limited to 100 shareholders who must be U.S. citizens.

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If you're looking for help with C-Corp vs. S-Corp, we can help you understand the differences between the two types of organizational structures and set you up with the right structure, get in touch with us.

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