S-Corp vs C-Corp and how to decide what's best

First of all, congratulations; you have successfully grown your dream into a viable business, and are now ready to register it as an entity with the IRS. Although it may not be the most exciting thing you do, it is important to do diligent research when deciding which entity you want to choose for your business. In this article, we will compare and contrast two options, the default C-Corp and the more specialty S-Corp.

S-Corp vs C-Corp: two popular, yet distinct types of business entities that are legally recognized in the US. Generally speaking, S-Corps enjoy many of the same benefits as C-Corps while also avoiding double taxation. However, there are some drawbacks associated with both entities and it's important to understand what they are before deciding which one is best for your business.

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Understanding S-Corps

An S-Corp, or Small Business Corporation, is a business entity that provides liability protection and pass-through taxation. This means that the profits and losses of the business flow through to its owners (shareholders) who pay taxes on their individual tax returns. It also means that the shareholders are not personally liable for debts incurred by the company.

In simpler terms, with an S-Corp, no taxes are paid at the corporate level. This is not the default corporation setup laid out by the IRS, instead, it is used to only pay a single-level tax.

__Here are a few key points to understanding S-Corps: __

Pass-through taxation: One of the main advantages of an S-Corp is that it's a pass-through entity for tax purposes. This means that the company's profits or losses are passed directly to the owners' personal income without being subject to corporate tax rates.

Limited liability protection: Like other corporations, S-Corps provide their shareholders with limited liability protection. This means that shareholders generally are not personally responsible for the corporation's debts and liabilities.

Ease of transfer: Ownership in an S-Corp can be freely transferred without facing adverse tax consequences or disturbing the corporation's existence. There are no restrictions on who can buy or sell the stock of an S-Corp.

Perpetual existence: S-Corps, like other types of corporations, have an unlimited life span; the corporation continues to exist even if the owner leaves the business or passes away.

There are a few disadvantages to an S-Corp however. S-Corps can't have more than 100 shareholders, and all shareholders must be U.S. citizens or residents. They cannot be owned by C corporations, other S corporations, LLCs, partnerships, or certain trusts.

Additionally, S-Corps are only allowed to have one class of stock, which can limit the corporation's ability to raise capital.

Understanding C-Corps

A C-Corporation (C-Corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C-Corps exist as separate legal entities and are governed by the laws of the state in which they are incorporated.

Most large corporations are registered with the IRS under the C-Corp label. C-Corps are more common than S-Corps, and their shareholders enjoy several benefits.

Limited liability: Shareholders have limited liability for the corporation's debts or judgments against the corporation.

Unlimited potential for growth: C-Corps can have an unlimited number of shareholders, allowing for increased potential to generate capital. They also may list their shares on exchanges and attract investors through initial public offerings (IPOs).

Ownership transferability: Shares in a C-Corp are generally easily transferable5.

Occasional tax advantages: A C-Corp may deduct the cost of benefits it provides to officers and employees, which can include retirement plans6.

By far, the largest drawback to a C-Corp is the concept of double taxation. Profits of a C-Corp are taxed to the corporation when earned, and then distributed to shareholders as dividends, which are then taxed on the shareholders' individual income tax returns.

As well as being taxed twice, C-Corps face extensive federal and state regulations and are required to follow stringent corporate governance procedures. Therefore, the cost and complexity of administering a C-Corp can sometimes be too much for small businesses.

S-Corp vs C-Corp: Key differences

Taxation:

S-Corp: S-Corps are pass-through entities, meaning the corporation itself is not subject to federal income tax. Instead, the company's profits or losses are passed through to shareholders who report them on their individual income tax returns.

C-Corp: C-Corps are subject to what is often referred to as "double taxation". First, the corporation pays taxes on its profits at the corporate level. Then, any distributed profits (dividends) are taxed again at the individual shareholder's personal income tax rate.

Business structure:

S-Corp: S-Corps have a specific business structure. They must have a board of directors and officers. The board generally manages business affairs and makes major decisions, while the officers manage daily business operations.

C-Corp: Like S-Corps, C-Corps also have a board of directors and officers. However, C-Corps have more flexibility when it comes to structuring the business and shaping the roles of directors and officers.

Ownership and stocks:

S-Corp: S-Corps have strict ownership rules. They can't have more than 100 shareholders, all of whom must be U.S. citizens or residents. S-Corps can only issue one class of stock.

C-Corp: C-Corps have no restrictions on the number or nationality of shareholders, and they can issue multiple classes of stock. This flexibility often makes C-Corps more attractive to outside investors.

Which is better for your business?

By reading through the differences between an S-Corp and C-Corp, you should already have an idea of which is the best for your business.

If avoiding double taxation is a priority, an S-Corp could be the better choice since it offers pass-through taxation. However, if you plan to reinvest profits back into the company, a C-Corp might be more advantageous as it could lower the overall tax burden.

Secondly, if you anticipate needing more than 100 shareholders or want to include non-U.S. citizens/residents or other corporations as shareholders, a C-Corp would be necessary.

Keep in mind that a C-Corp might be more appealing to investors due to fewer ownership restrictions and the ability to issue multiple classes of stock.

Examples of businesses that might benefit more from each structure

S-Corp: Small to mid-size businesses that will likely stay privately owned could benefit from S-Corp status. This includes businesses where all owners can be U.S. citizens or residents and are likely to remain below 100 in number. Think family businesses, local retailers, and small service providers.

C-Corp: Larger businesses that aim for significant growth, potentially going public, and attracting venture capital might benefit more from a C-Corp structure. High-tech startups, large retail chains, and manufacturing companies often choose this structure due to the ease of transferring ownership and attracting investors.

How to set up an S-Corp or C-Corp

Setting up either of these corporation types isn't easy, but can be done by following the right steps. We won't cover every little detail in the article, but can provide some basic steps that you should think about when setting up either an S-Corp or a C-Corp.

Remember, it's important to consult with a business advisor or legal professional when setting up either an S-Corp or a C-Corp.

1. Choose a business name: Ensure the name is available in your state and does not infringe on any trademarks.

2. File articles of incorporation: Submit these with the secretary of state in the state where you plan to incorporate.

3. Appoint a registered agent: This person or entity will receive legal papers on behalf of the corporation.

4. Create corporate bylaws: These outline the rules of the corporation and define its structure.

5. Issue stock: Issue stock to the initial shareholders of the corporation.

6. Apply for an EIN: Apply for an Employer Identification Number (EIN) from the IRS, which is used for tax purposes.

To convert the default C-Corp structure to an S-Corp, you will need to:

File Form 2553 with the IRS: This form is required to elect S-Corp status. The form must be filed within 75 days of the start of your corporation or within 75 days of a new year.

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