Legal

C Corp vs S Corp: Which is Best for Your Business?

Legal

Setting up your business is an exciting endeavor, but also one you shouldn’t take lightly. Ensuring you set up your business entity right from the start will not only save you headaches and sleepless nights down the line but also a lot of money. Here are some important factors to consider to help you decide between a S-corp and C-corp.

What is a C-Corporation?

A C-corporation (C-Corp) is the default type of corporation. Shareholders own the corporation and are afforded limited liability protection, meaning that shareholders are not personally liable for the corporation’s debts or other obligations. While shareholders own the corporation, the shareholder-elected board of directors make the business decisions.

What is an S-Corporation?

A C-Corp may be converted into an S-Corporation (S-Corp) by filing the Form 2553 with the IRS and ensuring that all S-Corp guidelines are met. It gets its name because it is defined in Subchapter S of Chapter 1 of the Internal Revenue Code.

What is the Differences Between C-Corp and S-corp?

The differences between S-Corps and C-Corps boil down to two main categories: ownership and taxation.

1) Ownership – A major difference between the two designations is the restrictions on corporate ownership. C-Corps have no restrictions on ownership, with an unlimited number of shareholders and different classes of shareholders being permitted. Yet, S-Corps are restricted to no more than 100 shareholders, and those shareholders must be US citizens/residents. S-Corps are also limited to one class of stock, disregarding voting rights, meaning that there is only one kind of shareholder. Venture capital firms and angel investors prefer to hold preferred stock in a corporation, which is only an option in C-Corps. This makes it more difficult to raise capital as an S-Corp.

Furthermore, S-Corps cannot be owned by LLCs, C-Corps, other S-Corps, general partnerships, or most trusts. C-Corps can be owned by other corporations, LLCs, or trusts. C-Corporations therefore provide more flexibility when starting a business, especially if one plans to expand the ownership or sell the company.

2) Taxation – Taxation is often considered the most significant difference for business owners when deciding between an S-Corp or a C-Corp designation for their business.

C-Corps are subject to “double taxation” because C-Corps are separately taxable entities. First, the C-Corp is taxed at the corporate level when the owners file a corporate income tax return (Form 1120). The owners also face the possibility of being taxed again, as personal income, if corporate income is distributed to business owners as dividends. The only way for C-Corps to avoid double taxation is to reinvest all profits back into the business rather than paying a dividend. Wages and salary, including the owner’s salary, are generally considered deductible expenses. Yet, the IRS may “re-label” excessive salaries as a taxable dividend.

Taxes for S-Corps is a bit different. S-corporations are considered “pass-through” entities, where the business’s profits and losses are reported on the business owner’s income. S-Corps file an informational federal tax return (Form 1120S), but no income tax is paid at the corporate level. The profits and losses of the business are instead “passed-through” the business and are reported on the owners’ personal tax returns. Any tax due is paid for at the individual level by the owners.

Most states also pass profits and losses through to the owners of the S-Corp, with very few engaging in double-taxation of S-Corps. California is unusual among the states in that, while it does recognize the federal S-Corp designation, it does not treat S-Corps as pass-through entities for state tax purposes. Instead, California requires S-Corps to pay a 1.5% franchise tax on income, with a minimum tax of $800. In addition, an individual shareholder of an S-Corp will owe tax to the state on his or her share of the company’s income.

The Similarities Between The Two?

Both C-Corps and S-Corps are separate legal entities created by a state filing, in which limited liability protection is awarded to the owners of the company. The shareholders of C-Corps and S-Corps are the owners of the company and elect the board of directors, who in turn make the management and business decisions for the company. The corporate formalities of the two designations is also similar, with both required to follow the same internal and external obligations. These obligations include adopting bylaws, issuing stock, holding shareholder and director meetings, filing annual reports, and paying annual fees.

Lastly, C-Corps and S-corps have to file formation documents with the Secretary of State. These documents, typically called the Certification of Incorporation or Articles of Incorporation, are the same for both S-Corps and C-Corps.

How to Decide Between C-Corp and S-corp?

If you choose to structure your business entity as a corporation, you’ll be faced with an important decision—whether to select the designation of your business as a S-corporation or a C-corporation. This choice comes with implications for how much you will pay in taxes, the business’s ability to raise capital, and the ease in which your business can expand. Ultimately, the determination of whether an S-Corp or C-Corp designation is right for your business will depend on a closer analysis of your business needs. Consulting with an experienced attorney will ensure that you chose the best designation for your business.

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