S-Corporation vs. C-Corporation: Which One is Best for Your Business?

S-Corporation vs. C-Corporation: Which One is Best for Your Business?

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S-Corporation vs. C-Corporation: Which One is Best for Your Business?

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When you are launching a new business, it is a good practice to set up a separate legal entity for the company, such as a corporation.  Incorporation allows you to protect your personal assets from business creditors, creates a formal legal structure for operating your company, provides tax benefits and may make your company more attractive to lenders and shareholders.  The best type of corporation for your business depends on the intended strategy of your new company.  Two options are an S-Corporation or a C-Corporation.

How Are S-Corps and C-Corps similar?

S-Corps and C-Corps are very similar.  Both require setting up a separate legal entity, which has the authority to enter into contracts, own assets and hire employees.  Shareholders also have limited liability protection, meaning a creditor cannot seize their personal assets.

To establish either type of corporation, owners must file Articles (or Certificate) of Incorporation with a state’s Department of State.  Certain states, like Delaware, also require every corporation to have bylaws.  Even if bylaws are not mandatory in your state of incorporation, it is generally a good idea to have a set of rules that govern the internal affairs and day-to-day operations of your company.  It is equally recommended to adopt corporate resolutions, i.e. Directors’ Initial Resolutions and Shareholders’ Initial Resolutions, to approve all the initial actions taken by the incorporator, shareholders and/or directors.

Moreover, both types of corporations operate with a board of directors and have shareholders.  Day-to-day management is handled by a CEO (or president) and executives.  Pursuant to their bylaws, they must observe certain corporate formalities, such as having shareholders and board meetings, maintaining corporate records, preparing annual reports and other obligations.

What Are the Differences Between S-Corps and C-Corps?

There are some significant differences between the two types of corporations.  The primary ones relate to taxation, shareholder restrictions and the availability of multiple classes of stock.

S-Corporations are subject to the following rules:

  • Pass-through taxation. S-corps elect to have their profits “flow-through” the corporate entity directly to the shareholders.  As a result, the earnings of an S-Corp are only taxed once they reach the shareholders as profit, avoiding the double taxation of C-Corps.  Shareholders can deduct up to 20 percent of their business income as well as write off their business’s losses on their personal tax returns.
  • Shareholder restrictions. An S-Corp cannot have shareholders that are corporations, LLCs, partnerships or non-resident aliens.  Shareholders must be U.S. citizens, permanent residents or meet the “Substantial Presence Test” for residency.  There is also a cap on the number of shareholders—only a maximum of 100 shareholders is permitted.
  • One class of stock. S-Corps may only issue one class of stock, meaning that all outstanding shares must carry identical rights and privileges.  No preferred stock may be issued. 

C-Corporations differ as follows:

  • Default at formation. A C-Corp is the default entity when filing for incorporation.  In order to become an S-Corp, owners must file a federal election with the IRS to alter how they are taxed.  In addition, they may need to file an S-Corporation election with the Department of State of their respective State.
  • Double taxation. C-Corps are “double-taxed” meaning the corporation, as an entity, is taxed on its earnings and those same earnings are taxed once shareholders receive that profit as a dividend.  Owners cannot write off corporate losses on their personal income tax returns.
  • No owner restrictions. Unlike S-Corps, there are no restrictions on the number or type of shareholders.
  • Multiple classes of stock. Different classes of stock with preferential distribution of dividends and special voting rights are permitted.

Which Corporate Entity Should You Choose?

The best entity depends on your priorities and goals for the business.  C-Corps are easier to form as the default option.  They also offer flexibility in ownership in that there are no shareholder restrictions and the company can issue different classes of stock.  This can be helpful in allowing companies to give employees stock option incentives or attract various types of investors.  It also makes it easier to be acquired by another company or go public in the future.

However, if you are intending to remain a small company, these benefits may not outweigh the tax ramifications.  The significant problem with C-Corps is double taxation.  However, to counter this, the company can deduct 100 percent of their charitable contributions on their corporate return up to 10 percent of the company’s income.  In addition, C-Corps can deduct certain benefits from employees’ pay, such as health insurance, which may help them attract and retain employees.

S-Corps offer the most tax benefits, but they also tend to be more heavily scrutinized by taxing authorities.  Owners must take care to comply with all rules for S-Corps in order to maintain their preferred tax status.

The limitations on shareholders can make it more difficult for S-Corps to get investors and expand the business, especially outside the U.S.  However, it can also make it easier to manage the company and seek input from the owners.  S-Corporations tend to be a better fit for those who want owners to contribute to the company and are looking to remain smaller in size.

Note that there are other options besides an S-Corporation or C-Corporation.  Choosing an entity is an important decision.  Before you move forward, consult an experienced attorney to discuss the pros and cons.

Photo by The Climate Reality Project on Unsplash

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This Blog is made available by Romano Law PLLC for general informational and educational purposes only, not to provide specific legal advice. By using this Blog you understand that there is no attorney client relationship between you and Romano Law PLLC or any individual contributor. You should consult a licensed professional attorney for individual advice regarding your own situation.

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