Are you a small business owner who has outgrown the sole proprietorship structure and is considering incorporating your business? Transitioning to a more sophisticated structure could make a lot of sense, but there’s more than one option. Two prominent types of corporations are the S Corp and the C Corp. How do you decide which one makes the most sense for your business?
What you’ll learn
What you’ll learn
Key takeaways
- An S Corp allows pass-through taxation and offers potential tax savings, but has strict ownership and stock limitations
- A C Corp provides ample flexibility for raising capital and offering stock options, but is subject to double taxation and stringent compliance requirements
- The optimal business structure varies, depending on organizational needs, growth trajectory, and tax strategies
Determining which type of corporation is best depends on your management style, business size, growth potential, tax positions, and many other factors. Read on to get a foundational understanding of how these factors can influence the decision and the key distinctions between S Corps and C Corps.
How legal structure and governance differ between S Corps and C Corps
Under state laws, the legal framework of a C Corp is identical to that of an S Corp. In fact, all corporations start out as C Corps, and the process entails filing Articles of Incorporation with the Secretary of State.
All corporations are required to adopt bylaws to govern their operations, and all corporations must maintain a board of directors to oversee management. While this governance structure pertains to all corporations, some states allow for simplified rules for S Corps.
To transition your business from a C Corp and obtain S Corp status, you need to file IRS Form 2553 and elect pass-through taxation, which is the primary distinction between the C Corp and S Corp structures.
How do I know if my business is an S Corp or a C Corp?
“The C Corp vs. S Corp designation is a federal tax law distinction. All corporations start as C Corps but can transition to S Corp status, provided certain requirements are met. To transition a business, you must file Form 2553 with the IRS and elect S Corp status. If you run a corporation and have never filed Form 2553, it is a C Corp. Incidentally, the IRS requires C Corps to report their annual income via Form 1120, and it requires S Corps to report their annual income via Form 1120-S.”
— Tom Brock, CFA, CPA and OnPay Contributor
Understanding the key differences in taxation methods
For small business owners evaluating the C Corp vs. S Corp dilemma, the deciding factor usually pertains to federal taxation. As discussed below, these structures are taxed differently and have characteristics that extend beyond basic LLC tax benefits.
S Corp pass-through taxation
An S Corp is a pass-through taxation entity. S Corps are required to file an informational federal income tax return (Form 1120-S) on an annual basis, but no federal income taxes are levied at the corporate level. The business’s profits and losses “pass through” the corporation to its individual shareholders.
Each shareholder must report his or her share of the company’s income, losses, deductions, and credits on a personal tax return. This approach avoids double taxation and reduces tax liability when paying yourself as a business owner.
C Corp double taxation
A C Corp is a taxable entity that must pay corporate income tax on profits. Additionally, when a C Corp distributes profits to its shareholders, those profits are taxed via the shareholders’ personal returns. This dual wave of taxation is why C Corps are commonly referred to as double taxation entities.
To help us understand the nuance around this topic more, we asked Tom to weigh in once again based on his experience helping small businesses – regarding a question that many in the business world have.
Is an LLC an S Corp or a C Corp?
“A limited liability company (LLC) is neither an S Corp nor a C Corp. It is a distinct legal entity with a flexible tax classification. By default, a single-member LLC is treated as a disregarded entity (sole proprietorship for tax purposes), and a multi-member LLC is taxed as a partnership. However, an LLC can elect to be taxed as a corporation by filing the appropriate documentation with the IRS. This election is purely for tax purposes and does not change the LLC’s legal structure.”
— Tom Brock, CFA, CPA
Stock options and classes: Flexibility under each corporate structure
If your business files for S Corp status, the IRS will restrict you to issuing only a single class of stock. All shares will have identical economic rights, though voting rights can vary. This enables the IRS to maintain pass-through taxation, but it can limit your ability to offer equity incentives and attract varied investors.
In contrast, C Corp status offers the flexibility to issue multiple stock classes, such as common and preferred shares. The various classes of stock can have different economic rights and voting rights. This makes it easier to structure complex investment deals, attract institutional investors, and offer equity incentives to employees.
How employee benefits compare for S Corps and C Corps
With a C Corp structure, you can offer tax-free fringe benefits, such as health insurance, life insurance, adoption assistance, and retirement plans. Your business can fully deduct these benefits, and the IRS excludes them from your employees’ taxable income, even if they’re shareholder-employees.
On the flip side, the IRS is stricter for S Corps. An S Corp can deduct the expenses associated with fringe benefits, but many of the benefits are taxable for shareholder-employees that own more than 2% of the company.
Why some businesses choose to form an S Corp
As discussed below, there are several strategic advantages associated with electing an S Corp structure for your business.
Pass-through taxation
An S Corp avoids the double taxation that burdens a C Corp. It allows business owners to pass corporate income, losses, deductions, and credits through to its shareholders, who report them on their personal tax returns. As a result, S Corps pay taxes only at the individual level, unlike C Corps, which are taxed at both the entity and individual levels.
Potential tax savings on distributions
If you are an S Corp owner, you must pay yourself reasonable compensation, which is subject to payroll taxes, including Social Security and Medicare. That said, additional profits generated by the business can be distributed as dividends. These profits will trigger individual income tax, but they will not be subject to S Corp payroll taxes. Ultimately, this can reduce your overall tax burden and increase your after-tax profits.
Liability protection
Like a C Corp and multi-member LLC, an S Corp provides limited liability protection to its owners. It protects personal assets, like your home and retirement savings, from business debts and legal obligations.
“The optimal business structure varies from one situation to the next. It depends on your company’s short- and long-term goals, ownership structure, and tax strategy. S Corps offer pass-through taxation and relatively less stringent governance requirements than C Corps. This can make them more cost-effective and easier to maintain.”
— Tom Brock, CFA, CPA
Potential drawbacks of operating as an S Corp
While an S Corp offers several benefits, this type of business structure comes with some challenges worthy of consideration.
- Restrictions on ownership: Only 100 U.S.-based shareholders are permitted. Foreign investors, other corporations, partnerships, and other institutions cannot be shareholders.
- The single class of stock rule: You can only issue one class of stock, which limits your ability to differentiate investors’ rights and preferences.
- Barriers to rapid expansion: The restrictions noted above can make it difficult to raise capital and scale quickly.
Key advantages of choosing a C Corp structure
Incorporating as a C Corp offers your business the following advantages:
- Unlimited shareholders: There’s no cap on the number of types of shareholders. Foreign investors and virtually any type of entity can invest in a C Corp.
- Multiple stock classes: You can issue different classes with varying rights, such as preferred and common stock, to attract investors and differentiate rights and preferences.
- Better access to capital: The investor-centric structure makes attracting funding from venture capitalists and institutional investors easier, which can greatly facilitate growth potential.
“C Corps, on the other hand, are taxed separately from their owners, which results in double taxation (corporate income taxes on the entity’s profits and individual income taxes on distributed profits). The tax burden can be significant, but C Corps offer much greater flexibility than S Corps when it comes to raising capital and issuing multiple classes of stock with differentiated rights and preferences. C Corps are generally considered to be more sophisticated than S Corps.”
— Tom Brock, CFA, CPA
Disadvantages of a C Corp to keep in mind
While a C Corp offers a high degree of flexibility on the capital raising front, it comes with some challenges that can increase tax obligations and administrative workload, including those noted below.
- Double taxation: A C Corp’s profits are taxed once at the corporate level and again when distributed as dividends to shareholders.
- Complex compliance requirements: C Corps entail fairly rigorous governance standards, recordkeeping and reporting requirements, and regulatory obligations.
- Higher administrative costs: The complex compliance requirements mentioned above usually result in increased legal, accounting, and filing fees, making the typical C Corp a more expensive business structure than an S Corp or LLC.
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How to transition between an S Corp and a C Corp
If you maintain a C Corp and wish to transition to S Corp status to reduce your tax obligations, you must file Form 2553 with the IRS. All shareholders must sign the form, and it must be submitted within two months and 15 days from the start of the tax year in which you want the S Corp status to become effective.
Conversely, if you maintain an S Corp and wish to switch to C Corp status, you must revoke the S Corp status by filing a statement with the IRS, which must be signed by all shareholders holding more than 50% of the company’s stock. Following IRS approval, you will be free to expand your capital raising horizons, whether this means exploring access to venture capital, marketing your business to private institutional investors, or entertaining an initial public offering.
Choose the right business entity and stay compliant with tax laws with OnPay
Establishing the optimal legal structure for your company entails cultivating deep insights into the nature of your business and holistically assessing its growth potential, financing requirements, and tax exposures. Regardless of the path you take, a quality payroll provider can help you navigate through the ever-changing regulatory environment you’re bound to face. Expert support can help you ensure compliance with federal, state, and local tax laws, while freeing you up to focus on the core aspects of your business. The OnPay team has this expertise and is ready to help.
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.