Developing an idea and a market for your business is hard work, and it will take up most of your time as a new business owner. But don't forget the infrastructure of your business. According to the U.S. Small Business Administration, "Your business structure affects how much you pay in taxes, your ability to raise money, the paperwork you need to file, and your personal liability. ...Choose carefully." As your business develops, the initial choice you make for your business's incorporation will shape your financial plans, operational strategies, and more in the coming years. While it's tricky to see that far into the future, this guide can help you choose whether a C corporation or S corporation structure is best for your business. We'll cover the distinct characteristics of these two structures, their similarities, and their differences.
Characteristics of a C Corporation
C corporations are named after subchapter C of the IRS's internal revenue code. A C corporation is a separate tax structure from its owners; this means the corporation earns revenue and pays taxes on that revenue. Every C corporation is subject to corporate income taxes. The owners may be responsible for ensuring those taxes get paid, but they do not directly earn that money or owe those taxes. C corporations are the most common corporate structure in the United States, and it tends to be the default option.
Characteristics of an S Corporation
Also called a "flow-through entity," an S corporation is also named after the internal revenue subchapter that governs it: subchapter S. This corporate structure receives some tax benefits. However, it needs to meet moderately stringent S corporation guidelines and you must file Form 2553.
S Corp vs. C Corp: The Similarities
Now that you know the basics about the two different corporate structures, it's time to take a closer look at their similarities. Knowing the characteristics they share can help you ensure you have your bases covered, no matter what structure you choose.
Under both corporate entity types, there are business owners, and they're called shareholders. Profits are given to the shareholders, and those profits are called dividends. Shareholders receive dividends based on the proportion of the company they own. For example, a shareholder that owns 50% of the company will receive more in dividends than someone who owns 10%.
Both types of corporations are formed when the owners prepare their articles of incorporation, which is a document that officially establishes the legal creation of a corporation. The owners need to file the articles of incorporation and registration documents with the state. This registers the company as a C corporation; businesses can also file a Form 2553 to change the corporation to an S corp.
Limited Liability Protection
Both structures also offer their shareholders limited liability protection, and this is one of the key benefits of incorporation. If the corporation is sued, or any of multiple other negative circumstances occur, the shareholders and their personal assets have protection. Shareholders don't have to pay debts or penalties from their own personal holdings like they would with a sole proprietorship. While a C corporation or S corporation may go bankrupt, that won't bankrupt the owners.
Separate Legal Entities
As part of that liability protection, the corporation and its shareholders are considered separate legal entities. This creates a corporate shield of protection.
We already covered what shareholders are, but corporations also have directors and officers who run the business. Shareholders both own the business and elect the corporation's board of directors.
Corporations are formal entities with formal obligations. Those obligations include:
- Adopting bylaws
- Paying annual fees
- Creating annual reports
- Holding meetings for shareholders and directors
- Issuing stock
- Maintaining a registered agent and office
Both S corporations and C corporations have these responsibilities.
S Corp vs. C Corp: The Differences
While there are several similarities between the two structures, there are also important differences. Those include taxation and corporate ownership.
This is the factor you and your co-owners may consider to be the most important when choosing between corporate structures. Taxation requirements affect your business decisions, profits, and rate of growth.
C corporations must file taxes as a separate entity and pay corporate taxes. As a result, if your C corp pays out dividends to shareholders, that money will be taxed twice — once at the corporate level and again when the shareholders individually report the dividends as taxable income.
Because these are pass-through entities, the corporation just has to file an informational, or untaxed, federal return. There is no federal corporate tax, and both the profits and losses flow through the entity for owners to handle in their personal taxes.
States treat C corporations and S corporations the same, but the IRS puts more stringent demands on who can and cannot be shareholders in an S corp. So make sure you qualify before filing to be an S corporation.
C corps are relatively unlimited. They can have unlimited shareholders and multiple different stock classes.
S corporations can have shareholders who aren't U.S. citizens or U.S. residents, but they can have no more than 100 shareholders total. They can only have one type of stock class. Also, S corporations cannot organize themselves as being owned by other S corps, C corps, or many other types of business structures.
Which One Is Best for Your Small Business?
There's no one right answer for which corporate structure is best for your business. Instead, meet with a tax advisor who can help walk you through the tax implications of both options and advise you on what's the right fit for your business and your long-term business goals. Choosing a tax advisor and CPA who fits your business goals is critical for every step of starting and growing your business.
Schwartz & Associates Can Help You Strategically Form Your Business for Long-Term Success
Don't let the question of which corporate structure to use overshadow your business. At Schwartz & Associates, we help new business owners structure their businesses for success and smart tax strategies. If you want to learn more about whether your business should be an S corporation or a C corporation, schedule a discovery meeting with us to get started.