Starting or expanding a business involves critical decisions, one of which is selecting the right tax structure. S corporations (S corps) and C corporations (C corps) are two popular types of tax elections that businesses can choose. Understanding the differences between them can help you make an informed decision for your business.
What are the key differences between S Corps and C Corps?
Taxation: One of the most significant differences is in how they are taxed.
- S Corps: S corps avoid double taxation. They pass their income, losses, deductions, and credits directly to their shareholders, who report these on their personal tax returns. Hence why S corps are commonly referred to as “pass-through taxation entities.” This can lower personal income tax liability. To become an S corp, a business must file Form 2553 with the IRS.
- C Corps: C corps face double taxation. The corporation pays taxes on its profits, and shareholders also pay taxes on the dividends they receive. This structure might be less favorable for smaller businesses but allows more flexibility in growth and investment.
Ownership: Ownership rules also differ between the two structures.
- S Corps: S corps can have no more than 100 owners, all of whom must be U.S. citizens or residents. They must be a domestic entity and can only issue one class of stock, which can limit their ability to raise capital.
- C Corps: C corps have no restrictions on the number or type of shareholders and can issue multiple classes of stock, making them more appealing to a wide range of investors and better suited for businesses looking to grow significantly.
Corporate Governance and Legal Requirements
Both S corps and C corps provide limited liability protection, shielding owners’ personal assets from corporate debts and liabilities. They also share similar governance structures, requiring a board of directors, corporate officers, and adherence to corporate formalities like annual meetings and maintaining detailed records.
Employee Benefits
C Corps have more flexibility in offering employee benefits. They can provide a wide range of tax-deductible fringe benefits to employees, including health and life insurance, which are not taxable to the employee. S Corps have limitations in this area; benefits provided to employees who own more than 2% of the company are taxable to those employees.
LLCs and Corporations Electing S Corp Status
It’s important to note that S corp and C corp are tax elections, not types of business entities. LLCs and Corporations can both elect to be taxed as an S corp. This decision affects how the business is taxed but does not change the underlying business structure.
Why Would an LLC Elect to Be Taxed as an S Corp?
LLCs can be taxed as sole proprietorships (if it is a single-member LLC), partnerships, or S corps, all of which are pass-through taxation entities. So, if an LLC is already a pass-through entity for tax purposes, why would it elect to be an S corp? The main reason is employment taxes.
Here’s how it works:
- Partnership Taxation: If an LLC is taxed as a partnership, all profits are considered self-employment income, and the owner must pay self-employment taxes (which cover Social Security and Medicare) on the entire amount.
- S Corp Taxation: If an LLC elects to be taxed as an S corp, the owner can be considered both an owner and an employee. The owner-employee must receive a reasonable salary, and FICA taxes (Social Security and Medicare) are withheld and paid on that salary. However, any remaining profits after the salary are treated as distributions. These distributions are not subject to self-employment taxes, which can result in significant tax savings.
By electing S corp status, an LLC can lower its overall tax burden because only the salary is subject to employment taxes, while the remaining profits are not. This can be a substantial advantage for business owners looking to maximize their take-home income.
In sum, the Pros and Cons are:
S Corps:
- Pros:
- Pass-through taxation avoids double taxation.
- Potentially lower personal income tax rates for shareholders.
- Simple transfer of ownership.
- Cons:
- Limited to 100 shareholders.
- Only one class of stock.
- Restrictions on ownership by other entities and non-resident aliens.
C Corps:
- Pros:
- No restrictions on the number or type of shareholders.
- Ability to issue multiple classes of stock.
- Attractive to investors due to flexible ownership options.
- Can offer a wide range of employee benefits.
- Cons:
- Subject to double taxation.
- More complex and costly to establish and maintain.
- Higher administrative and compliance costs.
Steps to Elect S Corp Status
Businesses are automatically considered C corps by the IRS. To elect S corp status, follow these steps:
- Eligibility Check: Ensure your business meets the eligibility criteria for S corp status, including having no more than 100 shareholders, issuing only one class of stock, and having shareholders who are U.S. citizens or residents.
- File Form 2553: Complete and file Form 2553, “Election by a Small Business Corporation,” with the IRS. This form must be signed by all shareholders and filed within 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect.
- Maintain Eligibility: Continuously meet the eligibility requirements to retain your S corp status.
Making the Decision
When choosing between an S corp and a C corp, consider the size and goals of your business, tax implications, and your plans for raising capital.
- Smaller businesses might benefit more from the pass-through taxation of an S corp, which simplifies tax filings and can reduce personal tax liabilities.
- Larger businesses or those planning to expand rapidly and attract significant investment may prefer the flexibility of a C corp, despite the double taxation, due to its ability to issue multiple classes of stock and attract a diverse range of investors.
Evaluate your specific needs, financial situation, and long-term goals to determine the best structure for your business.
