Incorporating your business can secure assets, present tax breaks, and attract investors. But forming a corporation takes more than filing articles of incorporation. The Internal Revenue Service (IRS) requires that corporations choose one of two tax structures. When weighing an S corp vs. a C corp, the right choice isn't always obvious.
C corporation and S corporation designations are both strong choices. While they have some similarities, they also have some crucial differences. Before you make your decision, ensure you understand the pros and cons of each option. That way, you can rest assured you set up your corporation for success.
Overview: C corp vs. S corp
C corporations and S corporations share many similarities and a few crucial distinctions
Similarities include their:
- Liability protection
- Corporate structure
- Legal compliance standards
Differences include their:
- Formation process
- Taxation expectations
- Ownership structure
- Stocks and shares functionality
What is a C corporation?
C corporations exist as the default corporate tax structure. C corporations face double taxation, meaning they pay corporate income tax and individual income taxes on capital gains and dividends. They place fewer restrictions on shareholders and grow larger than most S corporations.
What is an S corporation?
The S corporation tax status lets corporate profits pass through to the owners' personal tax returns. While this avoids double taxation, S corporations adhere to additional legal guidelines and IRS scrutiny. As a result, they are less flexible and open to investors than C corporations.
Similarities between C corporations and S corporations
C corporations and S corporations have liability protection, their corporate structure, and legal compliance standards in common. You can form any corporation by filing articles of incorporation and registration documents with your state. By default, articles of incorporation create a C corporation. From here, some elect to become S corporations.
C corporations and S corporations have more in common than their initial formation. We'll break down the biggest similarities below:
All corporations provide limited personal liability for their owners. Under state law, all corporations exist as legally separate entities from owners.
As a separate legal entity, only corporate assets are subject to corporate debts. Although some exceptions exist, a shareholder is not personally liable for corporate debts. Corporations also protect shareholder assets from creditors.
Owners of a for-profit corporation, called shareholders, elect directors to oversee business operations. The directors hire officers to manage the day-to-day operations. Profits, called dividends, go to shareholders based on the number of shares each owns.
This structure works to ensure that owners get a return on their investment.
Legal compliance standards
To stay compliant, all C corporations and S corporations must:
- Issue stock
- Adopt bylaws
- Hold annual director and shareholder meetings
- Keep minutes of meetings
- Issue written corporate resolutions for significant decisions
- File annual reports with the state government
- Pay annual fees
Failure to perform these tasks can result in the loss of liability protection and dissolution of the corporation.
Differences between S corporations and C corporations
Differences between C corporations and S corporations include their formation, taxation, ownership, stock practices, and employee benefits. You can find the one right for you by distinguishing between these models. Keep these factors in mind when deciding between S corporations and C corporations:
All corporations begin as C corporations. A C corporation may convert to an S corp by filing IRS Form 2553, Election by a Small Business Corporation, with the IRS. There may also be state forms to file to obtain S corp status for state tax purposes.
S corporations get their name from provisions in the law that permit it 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 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.
The main reason for choosing an S corp is to save on taxes. With that in mind, there is a big difference between a C corp and an S corp file taxes.
- C corporation profits incur taxes that show up on the corporation's tax return. Any after-tax profits distributed to shareholders as dividends face taxes again. Shareholders also report this income on their personal tax returns. You can avoid double taxation 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. The profits (or losses) 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 engage in double taxation of S corporations.
A C corporations will provide more flexibility in selling shares of stock. 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 the company grow larger. For example, having more than one class of stock can help a business raise capital from investors without giving them voting rights.
Stocks and shares
C corporations appeal to investors. 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, S corporations 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
A company may choose to provide benefits to shareholders who are also employees, such as health, life, and disability insurance. C corporations can deduct the cost of such benefits, which aren't 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 benefits, and they become taxable to a shareholder who owns more than 2% of the stock.
C corp pros and cons
Every corporation spends some time under the C corp tax status. Whether they stay this way or convert to S corporations depends on their priorities and finances. We'll discuss the pros and cons.
C corp advantages
Most corporations take the C corp structure for a good reason. It's appealing to investors and flexible enough for most owners' needs. The main advantages include:
- Unlimited shareholders: Unlike S corporations, C corporations allow 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
C corp limitations
Despite their benefits, C corporations come with a few downsides including:
- Large and complex structure: C corporations can grow to massive sizes, requiring high labor costs and capable management
- Double taxation: C corp earnings face corporate income tax and personal income taxes
- No personal write-offs: Investors can't write off business losses on their personal income taxes
S corp pros and cons
S corporations combine some of a corporation's structural advantages with a partnership's tax incentives. For some businesses, this is a match made in heaven.
S corp benefits
Whether you want a streamlined ownership structure or the chance to save on taxes, S corporations deliver. Their main advantages include:
- Pass-through tax benefits: An S corporation does not pay corporate taxes at the federal level.
- Employee income: S corporation shareholders can work as employees 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 accrual accounting unless they fit the “small corporations" criteria and meet the IRS' gross receipts test. S corporations can use cash accounting 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 pay taxes on the distribution. With C corporations, the corporation pays taxes first, and shareholders pay taxes again once they receive their proceeds.
S corp limitations
S corporations come with plenty of appealing advantages. At the same time, their drawbacks keep many companies away. Limitations to look out for include:
- 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 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.
How to choose between an S corp and a C corp
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 greater flexibility to raise capital. However, whether an S corp vs. a C corp would be best for your business depends on careful analysis of various factors related to your particular situation.
You'll get closer to your ideal structure by asking these questions:
What is my ideal business size?
Generally, small businesses prefer S corp status since they fit within the legal limitations for an S corp. An S corp is often not available to large corporations, those with a lot of start-up capital, or those planning to sell stock globally.
Large corporations may prefer the flexibility of a C corp. Unlike an S corp they can:
- Have more than 100 shareholders
- Sell shares to investors who are not U.S. citizens or resident aliens
- Hold shares owned by other entities like corporations, LLCs, partnerships, and trusts
- Issue more than one class of stock
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 Corporations allow 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 investors tend to be more involved in operations than C corp shareholders. While S corporations consolidate control, they are harder to buy into.
Can you afford double taxation?
C corporations impose double taxation on corporate profits and personal income. S corporations only incur one round of taxes thanks to its pass-through taxation. Depending on your income tax rate and earnings, one option can return a lot more revenue than the other.
Can you handle IRS scrutiny?
Because of their tax arrangement, the IRS keeps closer tabs on S corporations. Avoiding accidents that lead to audits takes priority here. S corporations must also file additional forms to change their classification from a C corp.
Ready to form a C or S corporation?
Finding the proper business structure takes time and thoughtful consideration. While there's no easy way to get a business off the ground, you can work through the process in a few key steps:
- Choose a structure and confirm if a corporation is suitable for you. LLCs, partnerships, and sole proprietorships offer plenty of advantages. Review each business structure before filing articles of incorporation.
- Confirm that a for-profit model suits your business. Depending on the goals and finances that go into your business, you could file as a nonprofit. You can learn more about starting a nonprofit before committing.
- File articles of incorporation if the for-profit corporation status works best to form your corporation.
- Optional: Convert to an S corp by hosting an S corp election among owners. If a majority votes yes, you can make the change.
Refining your corporate strategy will help ensure you execute your business plans as seamlessly as possible. With a trustworthy attorney and help from LegalZoom, you can follow all the required steps to get your corporation off the ground.