Incorporating your company is an important step as a business owner, but it’s crucial that you understand which corporate tax classification to choose. Choosing between being an S corporation and a C corporation affects both your business and personal taxes as well as funding options and ownership structure.
If you’re about to incorporate your business, here are several considerations to keep in mind.
What is a C corporation?
In a C corporation (C corp), the company is a separate legal and tax-paying entity from its owners. This means the corporation reports and pays taxes on its own income at the corporate level while shareholders are taxed separately on any dividends they receive. This structure is often associated with larger or growth-focused businesses due to its flexibility in ownership and ability to raise capital. C corporations can have an unlimited number of shareholders, which makes them a great option for companies that plan to bring in investors as the company grows.
What is an S corporation?
An S corporation (S corp) election allows a qualifying business to pass its income, losses, deductions, and credits directly to its owners for tax purposes. The business itself generally does not pay federal income taxes.
S corporations must meet certain requirements, which include limits on the number and types of shareholders. This makes S corporations a popular option for small and midsized businesses. They protect owners from double taxation while providing legal protections that aren’t available for C corporations.
How to incorporate your company
No matter what type of structure you choose, the process of incorporating your business starts with filing articles of incorporation with the appropriate agency in your state. In most states, it is the Secretary of State. Many states allow businesses to file online. While the specific details vary between states, some pieces of information are virtually universal, including:
- Your company’s name
- Information about the registered agent for service of process
- Corporate structure type
- Details for the board of directors
- Authorized shares information
- Planned duration of the business
- Incorporator details
- Third-party filing information
After the state approves the articles of incorporation, the business is officially recognized as a corporation. At that point, eligible companies can decide between being an S corp and a C corp.
The differences between S corporations vs. C corporations
While S corporations and C corporations are both corporate tax classifications, there are some differences, including:
- Formation: If you incorporate your company, its default classification is a C corporation. You’ll need to take the extra step of filing IRS Form 2553 to classify your corporation as an S corporation.
- Taxation: An S corporation is a pass-through entity, meaning that its profits are passed along to its owners as taxable personal income. That’s why S corporation owners pay taxes only once, as personal taxes. The business income of a C corporation is taxed, so C corporation owners pay both personal and business taxes.
- Tax forms: While both S and C corporations must file the quarterly IRS Forms 941 and 1120-W, their annual tax form obligations differ. C corporations must file IRS Form 1120, whereas S corporations must file the slightly different IRS Form 1120S.
- Shareholders: For an S corporation to have shareholders, it must be a domestic corporation that offers only one class of stock to at most 100 shareholders. C corporations have no such restrictions.
How to choose between an S corporation and a C corporation
Choosing between an S corporation and a C corporation depends on how each structure aligns with your business goals, ownership plans, and financial strategy. Business owners may consider how profits will be distributed, how many shareholders the company has, and whether outside investors will be brought in to further fund the company’s growth. C corporations may offer more flexibility for raising capital and expanding ownership while S corporations are often preferred by businesses looking to simplify taxation through pass-through treatment.
Pros and cons of S corporations
Registering your company as an S corporation comes with specific pros and cons, including the following:
Pros of an S corporation
- Unlike C corps, S corps are considered pass-through entities, which means owners report net revenues as personal income. This prevents owners from having to claim these profits on their business taxes and personal taxes.
- If your S corporation incurs business losses, you can deduct them from your personal income on your annual tax return.
- Since an S corporation can have at most 100 shareholders, if your goal is to distribute your company’s profit among its owners rather than the public, an S corporation may allow you to do so.
Cons of an S corporation
- If your company plans to go public, the 100-shareholder limit of an S corporation may prevent you from doing so.
- Since S corporations are pass-through entities, investors may view them less favorably. This can make your company less appealing to outside investors.
- In an S corporation, you cannot issue preferred stock, which eliminates the owners’ voting rights while still allowing them to receive dividends before holders of common stock.
Pros and cons of C corporations
Registering your company as a C corporation comes with certain advantages and disadvantages, including the following:
Pros of a C corporation
- Businesses are automatically considered C corporations unless paperwork is filed to change it. This means that you don’t have to worry about additional paperwork unless you want to be an S corp.
- A C corporation can issue all kinds of stock to an unlimited number of all kinds of owners, including the public. This lack of limitations can be appealing for new companies looking to reinvest their profits back into the business.
- Since even other companies can own stock in a C corporation, registering your company as a C corporation opens your business to additional funding routes.
Cons of a C corporation
- Since C corporations are not pass-through entities, owners are subject to taxation on business profits as well as their personal income.
- C corporation owners cannot count business losses as personal tax write-offs.
- More formalities. A C corporation’s articles of incorporation require it to include bylaws that create more formalities for a company. These formalities include annual shareholder meetings, committee formation, and more.
Why it’s important to choose the right entity
The importance of properly choosing between an S corporation and a C corporation comes down to ownership, age, and funding sources.
- Ownership: If you want your owners to include other companies or any foreign entities, you’ll need a C corporation. If your owners will be entirely U.S.-based and plan to take out the company’s profits as distributions, choose an S corporation.
- Age: Newer companies planning to grow rapidly may prefer C corporations since their stockholder options are virtually limitless. Older companies that want to distribute their profits among their shareholders may prefer S corporations.
- Funding sources: If you seek money from institutional investors, you’ll need a C corporation. These funding sources can’t be accessed if your company is an S corporation. Instead, you might want to consider SBA or other types of loans.
When you need funding for your business, SmartBiz Bank® may be able to help. Find out if you pre-qualify today.
FAQs
What are the tax advantages of an S Corp compared to a C Corp?
An S corporation typically offers pass-through taxation, meaning business income is generally taxed only at the owner’s personal income tax level rather than at both the corporate and individual levels. In some cases, S corp owners may also reduce certain self-employment taxes by structuring compensation appropriately. However, the overall tax benefit depends on the business’s profitability and how income is distributed.
When should a business choose a C corporation over an S corporation?
A C corporation may be a better choice for businesses that plan to scale significantly or seek outside investment. This structure allows for unlimited shareholders and multiple classes of stock, which can be attractive to investors. C corporations may also be more suitable for companies that intend to retain earnings within the business for reinvestment.
What are the limitations or eligibility requirements for an S Corp?
To qualify as an S corporation, a business must meet specific IRS requirements. These typically include having no more than 100 shareholders, all of whom must be U.S. citizens or residents, and issuing only one class of stock.
How do ownership and shareholder rules differ between S Corps and C Corps?
S corporations have more restrictive ownership rules, including limits on the number and type of shareholders and a requirement to issue only one class of stock. These limitations are designed to maintain the simplicity of pass-through taxation. Conversely, C corporations may be able to have an unlimited number of shareholders, including institutional and foreign investors, and can issue multiple classes of stock.
