S Corporations vs. C Corporations

C and S corporations are different legal structures for doing business as a corporate business entity. While both structures are initially formed exactly the same way and have many similarities, there are also some notable differences. The biggest difference is that C corporations and the S corporations are taxed differently. Other differences include limits on the types of business that can be done, as well as citizenship or residence limits.

C Corporations

A C corporation is the default corporate structure. This means that anytime a business owner decides to form a corporation it is a C corporation, unless measures are taken to turn it into an S corporation. A C corporation is taxed separately from its individual owners. This means that the corporation’s profits are taxed through the corporation and the owners only pay taxes on the income they receive from the corporation. However, if the owners also make profits from the corporation in the form of dividends, these profits are also taxed as income, even though they have already been taxed through the corporation. This taxation system is often called double taxation.

C Corporation Benefits

While double taxation may seem like a drawback, there are benefits to sticking with the C corporation form. Because of this system of taxation, it is easier to build capital with a C corp. The taxes on the corporation are lower than individual income taxes and as long as the dividends stay within the corporation, this can quickly accumulate into capital for the corporation. Under the C corporation, owners can provide generous benefits to employees, which are tax-free to the employees and are write-offs for the corporation. A C corporation is the more flexible of the corporate structures and it may be more beneficial to large businesses than an S corporation. Additionally, foreign residents and nationals are allowed to form C corporations in the United States and any type of business can become a C corporation.

S Corporations

Once you have formed a corporation, you must take extra steps to turn the corporation from a C corporation into an S corporation. This is done by filing the appropriate forms with the IRS and if required, with your state. This can be done anytime after the corporation is formed. It may be wise to take the time to decide if the S corporation is the right structure for your business. Once all of the shareholders of the corporation have agreed, a 2553 form is filed with the IRS for pass-through taxation. Some states will automatically honor the S corporation once it is formed with the federal government, but some will not, so you should look into your own state incorporation laws to see if you need to file a tax form with the state as well. Further, some states tax S corporations differently than the federal government and some do not honor S corporations for tax purposes at all.

S Corporation Benefits

The biggest difference between the S corporation and the C corporation lies with pass-through taxation. Unlike the C corporation, where the corporate entity is taxed separately from its individual owners, the profits from the S corporation pass through to its owners, and the owners are taxed directly for the profits of the corporation. This can be beneficial when the owners want to receive profits from the corporation in addition to their income, but do not want to face the double taxation of the C corporation. Further, losses incurred from the S corporation may be deducted from the individuals tax return, up to the amount of their personal investment.

S Corporation Disadvantages

While this form of taxation has many benefits, the S corporation may not be the right corporation for all businesses. A downside to the S corporation is that individual income taxes are generally higher than corporate taxes, it may be harder to raise corporate capital in an S corporation. Further, only U.S. citizens or residents may form an S corporation. Some businesses such as banks, Domestic International Sales Corporations, and certain insurance corporations are prohibited from taking the S corporate structure. Shareholders that own more than 2% of an S corporation may not write off employee benefits from their taxes.

C and S Corporation Similarities

Whichever corporate structure you choose, both have many of the same benefits. Both types of corporations are separate entities, meaning that the individual owners enjoy protected liability under the “corporate veil.” S and C corporations are both treated as individuals by law, meaning that they can buy property and sue other businesses independently of their owners. Owners of both the S and C corporations can also raise additional capital by selling stock and transfer ownership by selling stock. Finally, both S and C corporations have an unlimited lifespan and can outlast the lives of all of their original owners, if allowed under state law.

Case Studies: S Corporations vs. C Corporations

Case Study 1: Tax Efficiency and Flexibility

A small business, Smith & Co., initially operated as a C corporation. However, as the company grew, the owners realized the burden of double taxation on corporate profits and dividends. They decided to convert their business into an S corporation to take advantage of pass-through taxation. This allowed them to avoid double taxation and allocate profits directly to their personal tax returns. The switch to an S corporation provided tax efficiency and greater flexibility in distributing earnings among the owners.

Case Study 2: Ineligibility for S Corporation Status

Jones Manufacturing, a manufacturing company, explored the option of becoming an S corporation. However, due to having non-resident alien shareholders, they were ineligible for S corporation status. They had to continue operating as a C corporation, subject to corporate-level taxes. This limitation highlighted the importance of understanding the eligibility requirements for S corporation election and considering the impact on the company’s ownership structure.

Case Study 3: Estate Planning and Succession

Johnson & Sons, a family-owned business, faced the challenge of transitioning ownership to the next generation. They chose to operate as an S corporation to facilitate smoother estate planning and succession. By utilizing the pass-through taxation of an S corporation, the family members could transfer shares to the next generation without triggering significant tax consequences. This allowed for seamless generational transfers and preserved the family’s control over the business.

Getting Legal Help

If you are interested in forming an S or a C corporation, but need more information or advice, you should contact an experienced business lawyer for assistance.