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S Corporations vs. C Corporations

When starting a new business, it is almost always a good idea to choose either a S Corporation, a C Corporation, or a Limited Liability Company (LLC) as a business form, since corporations will help to limit liability when dealing with the public. For a discussion of LLCs, please refer to our article on LLCs. Outside of LLCs, there are generally two different types of corporations from which to choose when deciding on the corporate type that is right for your business: S Corporations or C Corporations.

C Corporation

A C Corporation pays taxes under Subchapter C of the tax code. A C Corporation – also called a “profit corporation” – offers liability protection that is appealing to most big businesses as well as some small businesses. In a C Corporation, income taxes are paid by both the corporation and shareholders. If the C Corporation incurred any losses, those losses remain the property of the C Corporation and are made the responsibility of the shareholder. However, the owners of the C Corporation are not liable for any debts of the business, even in the case of a bankruptcy.

In a C Corporation, then, income taxes are paid twice: The corporation is taxed as one entity and the shareholders are also taxed separately. The corporation must pay federal taxes on all profits, and shareholders pay taxes on their dividends.

S Corporation

Like the C Corporation, the S Corporation is named after the Internal Revenue Code section that allows it. An S Corporation is a corporation which has chosen for its profits to be taxed in the same way as business that is not incorporated, meaning there is no double taxation. Like C Corporations, not all corporations can or should opt to become a S Corporation. Those applying for the status of S corporation are usually small businesses, such as sales, service, retail, professionals or family businesses. Also, companies that hold a lot of depreciating assets will generally choose the S Corporation form, since the depreciation can be passed on to the shareholders.

Subchapter S is usually ideal for smaller companies. These companies do not typically need to worry about shareholders as their number of shareholders is typically small. 
The S Corporation has a big advantage of avoiding double taxation – which is always a good thing. Another advantage of the S Corporation is that it does itself not pay federal taxes; profits pass through to individual stockholders, who then must report them on their individual tax returns. This is done through a K-1 tax form, which the corporation sends once a year to shareholders. The form reports the distribution of any income from the corporation to shareholders, as well any loss. It is then the shareholder’s responsibility to include this distribution of income or loss information in the filing of their own personal taxes. In choosing between a C Corporation and a S Corporation, due to the lack of double taxation a S Corporation is almost always the choice of small businesses.

So, why would anyone choose a C Corporation over a S Corporation?

If you are basing your corporate classification decision solely on tax benefits, than choosing a S Corporation may seem like the obvious answer. After all, who wants to have to pay taxes twice? However, there is more to making this decision than basing it on double taxation alone. Savvy big business owners know that double taxation issues can actually be neutralized through re-investing corporate earnings, which may result in lower tax rates. Using these kinds of strategies, tax rates applicable to many individuals in a C Corporation are lower than the rates that would apply to a S corporation even when the employees or owners of the two different corporations are at the same income level.

There are also tax-free fringe benefits for shareholder-employees of a C Corporation that may be unavailable to S Corporations, including such things as pension plan contributions and health care. The corporation can make pension fund contributions or buy health insurance for employees without having those benefits taxed. Plus, these pension fund and health insurance expenditures are actually tax deductions for the corporation. 
Another big employee advantage for those working for a C Corporation is that they may be offered a Flexible Benefit/Spending plan or Cafeteria Plan which, according to the IRSentitles employees, and their families to receive a variety of health benefits, offered by the corporation, and certain amount of payroll deductions are taken on a before-tax basis, which pays part of the expense or employer-sponsored salary reduction programs. Some of these benefits are not available to S Corporations.

Large companies also often choose the C Corporation business form because of their size and because their business is public in nature. A C Corporation is not restricted in the number of shares they issue the same way that a S Corporation is restricted. C Corporations can have a great deal more shareholders than a S Corporation, and the shares that are issued can be of varying classes. Furthermore, shareholders are not required to be U.S. Citizens or permanent residents as is the requirement to own stock under a S Corporation. If a company is looking for additional capital, the C Corporation therefore has greater opportunities for more rapid growth.

Similarities between the two corporation types

Generally, people think of the S Corporation and the C Corporation in terms of how they are different. However, it is also helpful to understand the ways in which they are similar. This may help to make the decision of deciding between the two a little easier as there are advantages that both classifications provide.

First, and probably most importantly, both types of corporations offer the same limited liability protection for shareholders/owners. By incorporating under either, you will still be protecting yourself from being personally responsible for the debts and liabilities of the business. The process of incorporating with the state is the same regardless of whether you decide to have your business be a S or a C Corporation; any corporation filed with the state is a C Corporation unless an election to change the status to S Corporation is filed out and sent to the feds. The corporation then becomes a S Corporation. Other than that election, the documents filed with the state are the same.

Also, both types of corporations have shareholders, directors and officers. In both cases, the shareholders are the owners of the company and these owners are responsible for the election of the board of directors. Organizationally, the two corporations are also the same in that the board of directors oversees and directs the affairs of the company and the directors elect officers to manage the daily affairs of the business. Both types of corporations are also required to follow the same formalities such as adopting bylaws, issuing shares of stock, and annual and shareholder meetings as well as the minutes of these meetings. They are also required to file the same appropriate annual reports required by each state and the fees associated with these reports.

Decisions about corporate forms are important and will have long-range consequences. If you are starting a business, you need a good legal team to advise you. Please contact us if you need more information or have questions regarding starting a new business.

Caleb Morgan