C-Corp VS S-Corp: What They Are, How They Differ, & How To Decide Which Is Right For Your Business
As a new business owner, you will need to make some decisions about your company’s structure and type. Whether you are an LLC or a Corporation, understanding business structures will help you make important decisions about tax structures and inform you about potential tax liabilities. If you see the terms C-Corp and S-Corp and don’t know how they apply to your business, keep on reading. Understanding these differences at the most basic levels is a job for your company’s legal and accounting teams, but as a small business owner, you should have a working knowledge of corporation types and how the differences could affect business.
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When you started your small business, you likely spent a good deal of time dreaming about marketing strategies, product design, and customer retention. Thinking about a company’s corporate structure and how that affects taxes, business decisions, and future financing is not as exciting of a topic, granted, but it’s important to understand these differences from the onset. Ultimately, the type of corporation you run also decides how your company is taxed, who is held liable for faults and mistakes, or even the type and number of shareholders you may have.
Corporate structures may be varied, but a corporation is essentially a company (or a group of individuals running a company) that operates as one entity for legal purposes. Incorporating requires specific regulations that do vary by state. Check with a legal representative in your area for your state requirements regarding corporations.
There are private corporations (whose company shares are not available for public purchase) and public corporations (whose company shares are available for public purchase). All corporations need a board of directors (even if that board of directors is one person: you), and at least one employee (could also be you), and an owner/shareholder (at least one, and could also be you; I think you sense a pattern).
A corporation has all the rights a legal individual would have regarding the business. The corporation can own property, be sued, engage in contracts, etc. When you incorporate your business, you are agreeing to certain terms and regulations (again, varies by state) in exchange for protection from business liabilities. Bottom line: If you’re starting a business and you want to protect your and your investor’s money in the event of business failure, you’ll want to first decide what type of business structure works best. You do not need to make your business an LLC or a corporation; however, there are benefits to protecting your personal assets from business liabilities, which in turn can make you appear more stable to outside investors.
After you decide how best to structure your business, you will need to decide what type of corporation your business will become. Your choices are a C Corporation, an S Corporation, or a Non-Profit Corporation (like a religious organization or educational entity). A C Corporation is the default corporation category; you must register and file additional paperwork to become an S-Corporation.
What Is A C Corporation?
A C Corporation is structured in such a way that the owner pays an income tax on personal earnings, but the business itself is taxed for all corporate income tax. This is the most traditional corporate structure and may sometimes be called the “ordinary” corporation. Business owners do not need to be US citizens and there is no limit to shareholders, but there is a risk for double taxation since profits can be taxed at the corporate and the personal income level.
What Is An S Corporation?
An S Corporation is a business that chooses to tax its earnings to the owners/shareholders on their personal income taxes. (There are certain Federal tax requirements for an S Corporation. For example, all owners/shareholders must be US Citizens and your company cannot have over 100 shareholders.) Sometimes known as a “pass-through entity”, an S Corporation simply passes the tax requirements through to the owners/shareholders per their shareholder agreement and state legal requirements. The business itself is not directly taxed on earnings.
Why does an S Corporation exist? The hope was that the subchapter S rules in the tax code could help level the playing field for small businesses. Both LLCs and S Corporations pass along taxes to owners directly, and by taxing the owners directly, the company can avoid double-taxation. Once a company grows too big (with more than 100 shareholders), it will automatically upgrade to C Corp status and lose its S Corporation eligibility.
C Corps VS S Corps: Key Differences
If you are a small business owner with the option to register as an S Corporation, what are the major differences? Here’s the breakdown:
1) Differences In Taxation
A C Corp taxes the personal dividends of its owners and the business independently. An S Corp passes the taxes directly to the owner’s personal income tax, bypassing business income tax and preventing double-taxation. The only way to avoid double-taxation if you are a C-Corp is to operate at a loss or reinvest profits back into the company. Under new tax regulations, C Corps pay a flat 21% federal tax. Owers of S Corporations, however, can claim a 20% business deduction from their personal returns.
Talk to a tax specialist about how these differences in taxation could affect your business. (And then compare to other business structures like a sole-proprietorship or LLC, which also operate as pass-through entities.)
2) Differences With Venture Capital
It is harder to raise venture capital with an S Corp. Stock options are limited. However, with a C Corp, there is no limit to the number or types of stock options that may be offered to shareholders. This is an advantage if your company is looking to grow and expand.
3) Differences With Owners & Shareholders
Again, this comes down to growth. An S Corp can only have up to 100 shareholders and all shareholders/owners must be US Citizens. With those restrictions, it is difficult for an S Corp to look appealing to investors and venture capitalists; and it’s especially limiting to any business interested in growing outside of the United States.
Which Is Right For Your Business?
Maybe you’re not ready to incorporate your business quite yet. That’s okay! However, if you’re thinking it’s time to make that leap, you might want to consider a few other things to help you sort out which one is a good fit.
Becoming an S Corp takes a bit more work and willingness to adhere to the strict guidelines required to maintain that status, and IRS penalties are severe. If you are a small business owner looking to incorporate and you fit the S Corp requirements, the tax benefits are the biggest advantage. An S Corp avoids double-taxation and business owners can claim 20% of their business income on their personal tax returns. Those two tax benefits are significant. If you’re small and staying small, an S Corp is a solid choice. But if you want room to grow and have aspirations of expanding stocks, shareholders, and overseas markets, then you may not enjoy the limitations of an S Corp.
Here are some good guidelines if you’re still stuck.
An S Corp would be good for your company if…
- You are fine with limited ownership options. (US Citizens only, fewer than 100 shareholders)
- You have no need for expanded stock options.
- You have an excellent accountant (an audit is likely: there are specific requirements needed to maintain status and S Corps face higher scrutiny).
- You are just starting out and might still be losing money.
A C Corp would be good for your company if…
- You don’t want the time/hassle of updating S Corp paperwork requirements.
- You want room to grow/expand ownership and stock options.
- Your company makes a significant number of charitable donations.
- You are making a profit and might want to shelter those profits.
Size and tax structure are the two key take-aways about the differences between C Corp and S Corp. Each state has different tax requirements and corporate business tax rates, so it’s important to check with a local tax expert to run numbers on your own tax situation. In general, once you’ve decided there is a benefit to incorporating, there will be some paperwork and hoops to jump through before you can pay corporate tax rates and earn stock options.
How To Register A C Corporation
Once you’re ready to incorporate, you will need to register your company as a C Corporation. Hire an attorney familiar with filing papers for incorporation or research solid online options. Fees are state-specific and run between $100-$800. Attorney fees are varied. After you draft and file your articles for incorporation and pay all your business licensing fees, corporation fees, and acquire your tax identification number, you’ll be ready to operate with the benefits of a C Corporation.
How To Register An S Corporation
Once you’re ready to incorporate, you may choose to take the next steps to become an S Corporation. Hire an attorney familiar with filing papers for incorporation or research solid online options. Fees are state-specific and run between $100-$800. Attorney fees are varied. After you have filed articles of incorporation with your state and paid any necessary fees, you may then register Form 2553 with the IRS.
Learn About Other Business Structures
There are tax benefits to corporations and the business structure helps provide additional liability protection. However, incorporating isn’t easy or cheap. Between the red-tape, the increased chance for an audit, and all the additional recordkeeping requirements needed to keep your status, you’ll want to have a team ready to implement changes to your company structure with ease. Are you still debating the right business structure for your small business? For more information on types of business structures, you can check out Merchant Maverick’s Types of Business Structures: The Complete Guide.