When you start a company, one of the key considerations you will have to make is what type of business entity to form. There are so many options: corporation, LLC, partnership, LP, LLP, etc. Then, within corporations there are different types as well: C corp, S corp, B corp. Plus, each entity type comes with further differences from state to state. It can be overwhelming to wrap your head around it all.
Many people are especially confused about the difference between a C corporation and S corporation, and understandably so. This post is meant to help clarify the distinction between C corporation vs. S corporation and help you decide which one is best for your business.
When you apply to incorporate a business within your state, the default formation is a C corporation. A C corporation can only become an S corporation after all shareholders consent to filing for status as an S corporation with the IRS. A C corporation may file for S corporation status any time after incorporation (as long as it is still eligible to do so).
In terms of governance, ownership, capital generation, and liability, S corporations and C corporations are quite similar. At the end of the day, both of them are still corporations. The S vs. C distinction is really just a “status” that comes with differences in taxation and flexibility of ownership.
Taxation Difference Between C Corporation and S Corporation
Electing to operate as an S corporation provides owners with a different way of being taxed compared to a traditional C corporation. A regular C corporation is treated as a separate taxable entity by the IRS. A C corporation is taxed at the corporate tax level, and then again at the personal income tax level when dividends (or payments) are made to the shareholders; this is why C corporations are known for having “Double Taxation.”
Contrarily, as an S corporation, the income and losses of the company are divided between the shareholders and pass through to their personal income taxes. Therefore, the S corporation is not taxed at the corporate level, but only the shareholders are taxed at the individual level.
Restrictions & Limitations for S Corporations
There are a few key restrictions on S corporations as well.
For one, an S corporation may not have more than 100 shareholders, and all shareholders must be US citizens or US residents. There are no such shareholder restrictions for a C corporation.
Furthermore, C corporations are allowed to divide up voting rights by issuing different classes of stock. S corporations are limited to one class of stock, giving all shareholders equal voting rights.
Finally, some types of businesses are not permitted to become S corporations. These include banks and some insurance companies, among other business types. C corporations are usually a better choice for large businesses with their sites set on an IPO due to their greater flexibility.
Benefits of S Corporations vs. C Corporations
Smaller firms tend to prefer S corporation status because it helps them avoid the double taxation that comes with classic C corporation status.
New corporations, most likely operating at a loss in their initial years, also benefit from S status. Owners can write off the losses of the business in their personal income statements, offsetting income from other sources.
When you choose to sell your business, it may be beneficial to do so as an S corporation. Taxable gains on S corporations are typically less than C corporations. Like C corporations, S corporations have an “unlimited life,” meaning they are separate entities that continue to exist after the death of the owners.
Formation of S Corporations
Generally, articles of incorporation should be filed with the Secretary of State, and a special tax form should be filed with federal and state tax authorities. An S corporation may choose to drop its S status and return to C status at any time, but must wait 5 years to refile for S status again.
Each state has different laws regarding the formation of an S corporation. Some states don’t even recognize S status. This means that your business may enjoy S status for federal tax purposes, but will be treated as a C corporation at the state taxation level. Consult with a lawyer and tax advisor to avoid any surprises.
Hopefully this info has helped you gain a better understanding of the difference between a C corporation and S corporation. But before you go about setting up anything on your own, it’s wise to discuss both options with an experienced lawyer. A lawyer will be able to guide you through the specifics as they relate to your business and help set you up for success.