If your business has outgrown being a sole proprietor or single-member LLC, it may be time to consider a corporate structure. When choosing between corporations, consider not only your current needs but future ones. There are two major organizational structures that have some similarities but create different opportunities to protect your business and potentially save on taxes. Learn all about an S Corp vs a C Corp and choose for yourself!
What is a corporation?
If you’re asking about the difference between a C Corp and an S Corp, it’s probably because you’ve heard about the benefits of incorporating. Yes, there are some great perks to moving your company from a sole proprietorship to corporation status.
For one, you get limited liability. If your company experiences liabilities or damages, it’s harder to pass on these losses to you. In other words, you’re less likely to be found personally liable for damages caused by your company. This is excellent news for those who own homes or other personal assets they want to keep separate from corporate assets.
While there are definite plusses in the “corporation” column, there’s an increase in paperwork, fees, and upkeep. For those who want to issue shares or have multiple owners, however, a corporation is one of the best structures for a business.
C Corp vs S Corp Taxation
How are S Corps taxed?
The main difference between an S Corp and C Corp is the federal tax treatment. An S Corp is considered a “pass-through” entity. This means business income is taxed just once at the individual owner’s level. An individual owner would pay themselves a salary, which is taxed as employee earnings, but not subject to the self-employment taxes that a sole proprietor would pay. If an S Corp has multiple members, then each member reports their individual earnings or salary as income in the same way.
While S Corps are taxed as pass-through entities and taxed at the individual level, they are taxed differently from the typical self-employed sole proprietor. S Corps members don’t pay self-employment tax. Instead, S Corp members must be employees of their businesses and paid a “reasonable compensation”.
The owner-employee’s wages are subject to FICA payroll taxes, which total 15.3% and these taxes go towards the employee’s Social Security and Medicare. Half of the payroll tax (7.65%) is paid by the employer (aka your business), while the other half (7.65%) is paid by the employee. S Corp owners also pay income tax on their employee wages at their personal tax rate.
How are C Corps taxed?
A C Corp, on the other hand, gets taxed twice. The company itself pays a corporate income tax, both at the federal level and (if the state it’s incorporated in requires corporate income tax) at the state level. Then, each shareholder or employee owner pays taxes again when they receive dividends.
Like an S Corp, the compensation of officer C Corp owners should be fair. The IRS expects (and will check) to see that you are paying yourself a suitable salary; low-balling your compensation as a way to avoid paying income taxes could get you into big trouble.
The big takeaway here: C Corp owners pay taxes twice (at the corporate and individual level) and S Corp owners only pay income taxes on the combined earnings of the owner-employee’s wages and pass-through profits.
Pros and cons of S Corp vs C Corp taxation
C Corps are designed to handle cash flow in several ways to reduce the tax burden, including having more shareholders to split the profits; an S Corp is pretty limited in what it can do since earnings are taxed as personal income to shareholders and rarely any other way.
There’s another drawback to the S Corp that some people aren’t aware of, the Excess Net Passive Income tax. This tax is applied at the corporate level when passive income exceeds 25% of gross income. (Common passive income sources include interest on loans, rents, and royalties.)
This is where it pays to have a professional on your side to help you do the math and find the best structure and filing methods for the biggest benefits. Will they pick C Corp or S Corp? Your unique situation will help them decide.
Other differences to consider
While tax and cash savings are the most talked-about differences between a S Corp and C Corp, they aren’t the only way these corporations differ. In addition to how each is formed, including the paperwork and fees required, there are limitations as to who can create each type of corporation.
S Corps are limited to U.S. residents only, and there’s a cap of 100 shareholders total. If you want to expand your business to include hundreds or even thousands of shareholders, there is more work and planning involved to achieve this.
C Corps can have an unlimited number of owners. Plus, you can form a C Corp even if you aren’t a U.S. resident. This is an ideal option for international investors and entrepreneurs who want to build a new business in the States. For those with global interests, the choice of S Corp or C Corp may come down to location.
S Corp advantages
If simplicity, including the ability to file your taxes as part of your personal return, is your jam, an S Corp might be for you. Just remember that S Corps still have to file business returns and may have to file business returns with their state. Also, S elections are only guaranteed at a federal level.
S Corp owners also enjoy some perks granted by the Tax Cuts and Jobs Act, including the 20% pass-through deduction on qualified business income.
If you have losses in your business, you may be able to claim these losses on your personal tax return, which can help offset earnings from other personal income, also known as “loss balancing.” Because of this tax structure, you pay taxes one time on your business earnings; you avoid double taxation–probably one of the most important advantages of an S Corp vs C Corp.
While you’ll have to file some documents in the beginning, pay setup fees and assign an agent, it’s a relatively painless process to create an S Corp. You won’t need the input of many board members or partners unless your company is large. Freelancers and independent contractors often shift from a sole proprietorship to an S Corp for liability protections and tax advantages.
Once formed, maintaining your S Corp is as simple as filing a form with your state office confirming that nothing significant has changed since the previous year. Incorporation fees, filing fees, and licensing fees may be lower, too.
S Corp drawbacks
By default, a corporation is taxed as a C Corp and a single-member LLC is taxed as a sole proprietor, but if you qualify, you can elect to be taxed as an S Corp. To get this tax status, file form 2553 with the IRS. If you prefer simplicity, the S Corp may not be an attractive option in the beginning—especially if you hate filling out forms.
You can’t start an S Corp if you aren’t a U.S. resident. If you’re a US non-resident, you may have to find a different route.
Another drawback is that S Corps have been under intense scrutiny over the past 15 years, as part of initiatives by the IRS to curb abuse of the taxation structure of these corporations. Random audits are common. While you should use the services of an accountant and tax consultant to keep your dealings aboveboard, the hassle of an audit is real.
C Corp advantages
As we mentioned, forming a C Corp is a simpler process. By default, corporations are C Corps for federal tax purposes.
This structure also allows for more than 100 owners or shareholders, and they don’t have to be U.S. residents. Forming a C Corp may make your business more attractive for investors or in a sale as well, since it can be easier to transfer ownership of shares in a C Corp.
C Corp drawbacks
Remember that double-taxation thing? That’s a real downer for team C Corp. This doesn’t mean you’ll always pay more taxes as a C Corp, since corporate tax rates can be lower for those in higher tax brackets. For those looking to offset profits in one business with losses in another, however, the C Corp might be limiting.
Things to ask when considering an S Corp vs C Corp
Be honest about what you want in a corporation and how your future needs will look.
If you answer “yes” to the following questions, then you may be a fit for the S Corp!
- Am I a U.S. resident with 100 or fewer shareholders in our short-term plans?
- Do I prefer the perks of being taxed just once, enjoying 20% QBI deductions, and loss balancing against other forms of income?
- Am I looking at possible asset liquidation or a complete selling off of my business in the next 10 years?
You may be a fit for the C Corp if you answer “yes” to these questions:
- Would I like to sell shares of my business in the future?
- Am I looking to grow my business to include more than 100 shareholders?
- Am I a US non-resident?
- Am I interested in investments from angel investors?
- Am I a high rate taxpayer that may benefit from lower corporate income tax rates?
C Corp vs S Corp: Final thoughts
In the decision between C Corp or S Corp, it may help to see what other successful businesses in your industry are doing. If you’re a small family-owned business with no interest in expanding to international ownership, issuing mixed types of shares or selling to a big brand in the future, then an S Corp may suit you nicely.
On the other hand, if you’re destined to be the next big franchise with the possibility of becoming publicly traded or attracting the interest of foreign investors, the C Corp structure is likely ideal. Beyond these big goals, there are the tax details to consider. In the end, your choice may be as simple as “Do I want to be double-taxed?” That’s the criteria many S Corp owners have used to support their decision, and it’s worked out well for them.
What happens if you change your mind? The IRS acknowledges that it may make sense to change from an S Corp to a C Corp (and vice versa). By revoking their S Corp election, they can take advantage of a new, lower 21% flat corporate tax rate, which may provide significant savings over the personal income tax rate to which S Corp earnings and profits are subject.
You can also change from a C Corp to an S Corp, but you’ll need the unanimous consent of all your shareholders. Whether you have three or 3,000, every single one has to agree to the switch. Once they’re on board, use these IRS guidelines to make a move.
Talking to your tax adviser is key before making any decision that affects your business structure. Carefully consider the pros and cons we’ve mentioned to ensure a successful outcome.
Linsey Knerl is a Midwest-based author, public speaker, and member of the ASJA. She has a passion for helping small business owners do more with their resources via the latest tech and finance solutions.