C Corporation or S Corporation: What’s the Difference?
C corporations and S corporations are both real types of corporations that offer limited liability protection. However, the tax rules, registration requirements, and reporting expectations differ significantly. The biggest difference between an S corp and a C corp is how each structure is taxed.
As a founder, deciding on the right type of corporation depends on your organization's size, goals, and investor plans.
What Is a C Corporation?
A C corporation is a type of business structure where the owner’s assets are separate from the company’s assets. The owners of a C corporation are also known as the shareholders. When the C corporation is formed, the shareholders contribute assets and capital to it. In return, they receive shares in the corporation and are entitled to any dividends paid. If the corporation is dissolved in the future, the shareholders receive a proportionate division of the corporation’s remaining assets after creditors have been paid.
C corps are the default type of corporation. When you invest in a U.S. stock, the underlying business is often a C corp. Unlike S corporations, it is taxed at the corporate level. C corps must pay a federal tax of 21% on corporate earnings. Depending on the state, a state tax on corporate income may also be necessary.
How C Corp Taxation Works
In practice, the 21% federal tax on corporate profits means business earnings are taxed twice. The corporation’s earnings are first taxed by the federal government after Form 1120 is filed. If the corporation pays dividends to shareholders, the shareholders will have to pay taxes as well.
Who Can Own a C Corp?
One of the biggest differences between an S corp and a C corp is in ownership restrictions. A corporation can have unlimited shareholders. Many types of trusts or corporations can own a C corp. Additionally, foreign nationals are allowed to buy shares.
Because of this, C corporations are popular among businesses that want to attract outside investors. If you are thinking of going public through an initial public offering (IPO) in the future, your business will need to be a C corp.
What Is an S Corporation?
An S corp is a special tax election that offers tax savings once a corporation reaches around $80,000 in profits. Once you file Form 2553 with the Internal Revenue Service (IRS), you can officially be taxed as an S corp. Besides affecting how you file taxes with the IRS, it also impacts some of your filing requirements, investor options, and liability.
How S Corp Taxation Works
S corps are subject to pass-through taxation. This means that the S corp’s profits and losses are passed through to the owner. Unlike C corps, S corps don’t deal with double taxation.
Instead, you can use the Qualified Business Income (QBI) deduction to deduct 20% of your S corp profits, although wage limitations and other rules apply. In addition to the QBI deduction, an S corp election affects your taxes in other ways as well. Under IRS rules, S corp owners must be paid a reasonable salary. A reasonable salary is determined based on the individual’s training, hours worked, payments to non-shareholder employees, job duties, compensation agreements, dividend history, and any formulas used for calculating the salary.
The owner’s salary is paid with a standard W-2. Then, the QBI deduction can be used on the remaining profits that are passed through to the owner’s tax return. The profits that are passed to the owner’s tax return are known as the owner distribution. Unlike the owner’s W-2 salary from the S corp, these distributions are not subject to payroll taxes.
It’s important to note that pass-through income and owner distributions are not the same thing. The pass-through income is what you must pay taxes on, while the owner distribution is the actual movement of funds that end up in your account.
S Corp Eligibility Requirements
With an S corporation, specific rules must be followed. S corp shareholders must be United States citizens or residents. There can also be a maximum of 100 shareholders and a single class of stock.
If any of these rules are broken, your S corp status can be automatically revoked. When this occurs, your entity reverts to C corp status and is subject to double taxation. Additionally, entities that lose S corp status are barred from forming another S corp for 5 years, though the IRS may make exceptions to this rule.
C Corp vs. S Corp: Key Differences
So, what is the difference between an S corp and a C corp? To get a better understanding of how these corporate structures work in practice, let’s dive into key differences involving taxation, stock classes, ownership, investors, and employee benefits.
Taxation
When it comes to taxation, C corps face double taxation on profits distributed to shareholders. The C corp’s profits are taxed at a 21% federal corporate tax rate. Then, shareholder dividends are taxed on the shareholder’s personal tax return. State-level income and corporate taxes may also apply.
S corp profits and losses pass through to the shareholders, so only a single layer of taxation occurs. The S corp is taxed only at the individual level, based on its owners’ personal income tax returns. In most states, there is no state income tax on S corporations. However, there may be franchise, excise, and entity-level taxes.
Let’s see what an S corp and a C corp’s federal taxes look like in action.
|
C Corporation |
S Corporation | |
|
Revenue |
$200,000 |
$200,000 |
|
Expenses |
$100,000 |
$100,000 |
|
Salary |
$0 |
$50,000 |
|
Remaining Profit |
$100,000 |
$50,000 |
|
Payroll Taxes (Employee) |
$0 |
$3,825 |
|
Payroll Taxes (Employer) |
$0 |
$3,825 |
|
Corporate Tax |
$21,000 |
$0 |
|
Remaining Profit After Corporate and Payroll Taxes |
$79,000 |
$46,175 |
|
QBI Deduction |
$0 |
$9,235 |
|
Reasonable Estimate for Shareholder Dividend Tax at a 12% Tax Rate for Married Filing Jointly (C Corp) |
$0 | |
|
Reasonable Estimate for Federal Income Tax (S Corp) |
$0 |
$8,600 |
|
Total Federal Tax |
$30,480 |
$16,250 |
|
Owner Keeps |
$69,520 |
$83,750 |
For many profitable small and medium-sized businesses, S corporations are the most effective tax structure. C corporations become more tax efficient when the company retains profits. When a C corp keeps its earnings to invest in future growth, the owner doesn’t receive any dividends. Because only the 21% corporate tax rate applies, this scenario can significantly reduce the owner’s immediate tax bill.
Ownership and Shareholders
Another key difference between a C corporation and an S corporation concerns ownership. A C corporation can have an unlimited number of shareholders, and there are no limitations on shareholders' nationalities or entity types.
In comparison, S corporations are limited to shareholders who are United States citizens or residents. There is also a maximum of 100 shareholders allowed, and corporations cannot be shareholders. If any of these rules are violated, the S corp automatically loses its S corp election status.
Common Stock
A C corporation may issue common and preferred stock, making it more appealing to investors. For a C corp, offering multiple stock options provides greater flexibility in attracting employees through stock-based compensation. Having different types of stock can also provide varying voting rights, dividend options, and liquidation options. Corporations can adjust their stock offerings to feature the right level of ownership and control.
S corporations are only allowed to have one class of stock. This can impact investment opportunities because many investors want preferred stock, dividends, and other privileges.
Raising Capital and Investors
C corps are the standard option for raising capital from investors. In addition to offering the flexibility of preferred stock, C corps can issue an IPO. S corps are limited in the number of investors, investor nationalities, and stock classes they can have. As a result, C corporations are the clear winners when it comes to raising capital.
Employee Benefits and Deductions
There are specific requirements in place for employee benefits and deductions. With an S corporation, the owner must be paid a reasonable salary. If this salary is set too low, it can trigger an IRS audit.
C corporations can generally deduct the health insurance and fringe benefits they provide to owner-operators. This includes health insurance, health reimbursement arrangements, life insurance, disability insurance, educational assistance, transportation passes, and other fringe benefits.
C Corporation: Pros and Cons
To get a better understanding of an S corp vs. a C corp, let’s check out some of the major pros and cons associated with running a C corporation.
Advantages of a C Corp
When you operate a C corporation, there are a few distinct benefits you can take advantage of. Through a C corp, you can:
- Use different classes of stock, including preferred stock
- Deduct employee benefits
- Raise capital and attract investors more easily
- Enjoy having no limitations on the number or nationality of shareholders
- Prepare for a future IPO
Disadvantages of a C Corp
While there are benefits to choosing a C corporation vs. an S corporation, there are also risks and drawbacks that companies should be aware of. As a C corp shareholder, you will:
- Face double taxation on any dividends paid to shareholders
- Navigate more complex compliance requirements
- Be unable to pass profits directly to the shareholders
- Deal with a structure that is less convenient and tax-efficient for small businesses
S Corporation: Pros and Cons
While there are many advantages to setting up your business as an S corp, this choice isn’t right for everyone.
Advantages of an S Corp
By choosing to set up an S corp, your company can enjoy a few key benefits. As the S corp owner, you can:
- Avoid double taxation as a pass-through business
- Use your QBI deduction eligibility to save on your tax return
- Take advantage of payroll tax savings on your owner distributions
- Enjoy a simpler compliance process
Disadvantages of an S Corp
However, setting up an S corp also carries specific risks. An S corp owner must:
- Deal with strict ownership restrictions
- Issue a single class of stock
- Turn down foreign investors
- Pay a reasonable salary to the owner
Which One Is Right for Your Business?
By learning about the difference between an S corp and a C corp, you can make the best choice for your business. Each structure has its benefits, so the right selection depends on your goals, size, and funding needs.
When To Choose a C Corp
If the following descriptions describe your situation, a C corp is likely the best choice.
Investor and Venture Capital (VC) Funding Is Needed
When it comes to attracting investors, C corporations face fewer restrictions. Many investors prefer C corporations, which make it easier to attract capital investment in your business.
You Have Foreign Shareholders
C corporations are the only structure that allows for foreign shareholders.
Your Company Plans To Go Public
To release an IPO in the future, you’ll need to structure your business as a C corp.
Profits Will Be Reinvested
While double taxation is a major drawback of C corps, it isn’t an issue if you plan on investing your company’s profits into the business instead of paying a dividend. In this circumstance, the double taxation issue goes away.
You Need Multiple Stock Classes
S corporations only allow stock to be issued as a single class. If you want to issue preferred and common stock, you’ll need a C corp.
When To Choose an S Corp
In the following situations, choosing an S corp may make more sense.
You Have a Smaller, Owner-Operated Business
For many small and medium-sized businesses, setting up an S corp will be much easier. The ongoing compliance is simpler, and many of the benefits of C corps aren’t needed for small, owner-operated companies.
Your Shareholders Are U.S. Citizens
S corporations can only be invested in by American citizens and residents. If you don’t have any foreign shareholders, an S corp may work for your needs.
There Is No Need for Outside Investors
If you don’t plan on bringing in outside investors and venture capital, a single class of stock will likely be enough for your business.
You Want To Avoid Double Taxation
Any dividends paid by a C corp are effectively taxed twice. By opting for an S corp, you can avoid double taxation.
The Company’s Net Profit Is Above $80,000
Running an S corp requires more administrative costs, such as filing fees, payroll expenses, and the cost of preparing Form 1120-S each year. While each company has different expenses and payroll costs, most sole proprietors won’t benefit financially from an S corp until they reach the $80,000 threshold.
You Want To Save Money on Payroll Taxes
With an S corp, the owner must be paid a reasonable salary. After the reasonable salary is paid and expenses are subtracted, the remaining profits pass through to the owner’s taxes as an owner distribution. Unlike the salary payment, the owner distribution is not subject to payroll taxes.
How To Form a C Corp or S Corp
For a better understanding of S corporations and C corps, it helps to understand the formation requirements involved. While both corporate types begin with a state-level filing, S corporations also require an IRS step.
Steps To Form a C Corp
To create a C corp, there are a few important steps you will need to take. On top of your state and federal requirements, you will likely need to meet county and municipal requirements as well. To find out which business structures and permits are common in your industry, it helps to review your competitors' structures using EntityCheck’s Secretary of State (SOS) Business Search tool.
1. Choose the State
First, you need to select the state where you will be operating. Most small to medium-sized companies incorporate in their home state. If you choose to incorporate out of state, you will have to pay foreign qualification fees. Often, the added hassle and cost of registering as an out-of-state corporation negate the benefits.
For companies that are looking for the best out-of-state options, Delaware and Wyoming are two of the most popular choices. Thanks to its Court of Chancery, investor preferences, and business-friendly environment, more than two-thirds of Fortune 500 companies choose to incorporate in Delaware.
2. File Your Articles of Incorporation
To officially file your C corporation, you’ll need to submit your Articles of Incorporation and filing fee to your state’s Secretary of State. While each state is different, this document will normally request your company’s name, address, general purpose, the class of shares, and the number of shares. You’ll also need to provide your registered agent’s name and location.
3. Adopt Bylaws
The corporate bylaws are the basic rules that govern your corporation’s operations. It must include information about shareholder meetings, voting, and director duties.
4. Get an Employer Identification Number (EIN)
Your EIN allows you to hire employees. Often, banks and lenders require an EIN before setting up your company for a loan or bank account. You can easily apply for an EIN for free in about 15 minutes through the IRS. If you are unsure if you already have an EIN or want to see if your application has been processed, you can use EntityCheck’s Instant EIN Search.
5. Issue Shares
In your Articles of Incorporation, you must set the amount and value of your shares. Once the Board of Directors has been appointed and held its first meeting, the shares can be issued. The issuance and ownership of your shares must be carefully tracked in a cap table.
How To Elect S Corp Status
To apply your S corp status to the current tax year, you must file Form 2553 before March 15. If you just started your limited liability company (LLC), you have 75 days to elect S corp status. Some states also require a separate, state-level election, so look up the requirements for your state.
Besides Form 2553, you’ll need to set up an EIN, form an LLC (or elect S corp status as a C corp), and meet the S corp eligibility requirements. As an S corp, you also must designate a registered agent to accept legal documents and other correspondence during normal business hours.
To see how your business is currently registered or to look up how your competitors structured their companies, use EntityCheck’s SOS Search tool.
