When a new business decides to incorporate there are some things to decide early in the process. One of the issues a company needs to consider is whether or not to file an entity as an S corporation as opposed to a standard C corporation. There is really no difference between the two business entities as far as asset protection or estate planning goes, but there’s a huge difference in the way the two corporations are taxed.
The Difference Between C Corporations and S Corporations
C corporations are the publicly traded companies you see everyday on Wall Street such as Microsoft, Intel, or Apple. The defining feature of a C corporation is that they are taxed at the corporate level. A lot of small businesses don’t want to be taxed like this; they would rather be taxed at the owner or shareholder level. When businesses choose to be taxed at the owner level this classifies them as an S corporation. The main difference is how the owners want the profits and losses to be taxed. If they want the taxes to stay with the business then a C corporation is the appropriate choice and if they want to be taxed at the owner level then an S corporation classification is proper.
Both classifications offer limited liability protection, so shareholders are typically not personally responsible for company debts or liabilities. Both have shareholders, directors and officers. Shareholders are the owners of the company and elect the board of directors, who in turn oversee and direct corporation affairs and decision-making but are not responsible for day-to-day operations. The directors elect the officers to manage daily business affairs.
The big disadvantage to C-corp taxation is that distributions of profits, known as dividends, are subject to double taxation. In other words, the corporation is taxed once on its income, and then the shareholders are taxed upon any dividends they receive.
The Advantages of an S Corporation
It is important to know whether a company qualifies to make the S corporation selection. To be eligible to choose an S corporation the company must be domestic, not have more than 100 individual shareholders, shareholders must be U.S. residents, and certain business types like financial institutions are not allowed to use this classification. The main advantage of S corporations is that they are not subject to the standard corporate tax rate and may pass self-employment tax breaks to its members. Generally, S corporations are not subject to federal income tax other than tax on certain capital gains and passive income, S-corps are treated the same way as a partnership in the fact that taxes are not paid at the corporate level. Profits or losses of S corporations are passed directly to the shareholders as income, similar to that of a partnership, so there is no issue of double taxation because there is no tax liability on corporate income. Because the corporate profits pass through the business to shareholders income, shareholders can be taxed on money they did not receive. This could occur if the company elected to retain some of the profits and use it as working capital. On the plus side, the IRS allows S corporations to make additional distributions of profits to shareholders tax-free. However, this cannot be used as a mechanism to avoid the income tax liability the officers of the company should incur for the work that they did during that tax year. In other words the IRS expects S corporations to pay out a reasonable salary to officers that are actively involved in the company’s operations.
S corporations combine the benefits of partnerships (single taxation) with the limited liability offered by corporations. C corporations, on the other hand, allow for more flexibility in the number and type of shareholders, as well as different classes of stock. Understanding the differences, advantages, and disadvantages are crucial when deciding to incorporate a business.