C Corps and S Corps: Education 101
In today's world, choosing the type of business structure that you want for your company is an extremely important decision. There are many different components to consider by examining the advantages and disadvantages. If you have chosen the corporation business structure, your decisions are not yet complete. You must now decide whether to go with an S corp or a C corp.
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The Major Differences between an S Corp and a C Corp
In the articles of incorporation that you file with the Secretary of State, it does not distinguish between the two types of corporations. If you do not take action during the business formation process and choose between the two, it will automatically be a C corp. That is because all corporations that are filed under the subchapter "C" of the tax code are C corporations. The only way to change this, if you do prefer an S corp, is by filing for S status. The differences between the two are focused completely on taxes, so it is something to consider before you automatically convert to a C corp. When the one-page "S election" is filed with the IRS, the corporation is taxed like an LLC or a partnership. Below, we take a deeper look at the taxation differences.
- C Corps: C corps are separate taxable entities and as a result, they must file a corporate tax return via Form 1120. That means the corporation must pay taxes at the corporate level. A C corp is also subject to double taxation. The profit from a C corp is taxed twice: first on the net income and second at the shareholder level for the distributions. This is only the case if the corporate income is given to the business owners as dividends because it is considered to be personal income.
- S Corps: S corps are pass-through tax entities. To file taxes, they must use the Form 1120S which is an informational federal return. However, no income is taxed at the corporate level. They are considered pass-through tax entities because the profits and losses are passed through the business and then reported on the personal tax returns of the owner(s). Because of this, tax is only paid one time on the income via the individual tax returns.
- Personal Income Taxes: As far as taxes are concerned for both types of corporations, the only similarity is that personal income tax is due on any salary or dividend paid.
The Major Similarities of an S Corp and a C Corp
Although taxes are the biggest difference that separate the two business entities, there are many similarities between the two. No matter which one you choose, there are some benefits you can enjoy. These are some of the main similarities and benefits of each:
- Business Structure: For both types of corporations, the business structure is the same. Both of them have officers, directors, and shareholders. The shareholders of the corporation are also the owners of the company and are the people who elect the board of directors. The board of directors manage and direct the corporation's affairs as well as decision-making. However, they are not responsible for the daily operations. The board of directors elect the officers that manage the daily business tasks.
- Corporate Formalities: No matter which one you choose, the internal and external obligations and corporate formalities must be followed. As a requirement, some of these obligations include issuing stock, filing annual reports, paying annual fees, adopting bylaws, and holding shareholder and director meetings.
- Formation Requirements: To go along with these obligations, both must file their formation documents with the state. No matter which one you choose to go with, the documents are the same: articles of incorporation or a certificate of incorporation. The initial forms do not differ between the two.
- Limited Liability: One type of protection that both get to enjoy is limited liability. This is a huge benefit because it means that the owners or shareholders are not responsible for the debts and liabilities of the business. For example, debts that the corporation owes cannot be linked to the individual and the individual's property cannot be used to pay for these debts.
- Separate Entities: Whether you choose an S corp or a C corp, both are considered to be separate legal entities. They are both created by a state filing and this allows the corporation to enter into contracts, among other things, as its own legal entity.
Requirements for an S Corp or C Corp
For a corporation to be eligible for S corp status, the corporation must have a maximum of 100 shareholders. In addition to that requirement, the shareholders must all be U.S. citizens or resident aliens. The shareholders are generally individual shareholders as S corps are not eligible to be owned by a C corp, another S corp, an LLC, a partnership, or a trust. The corporation must also have a calendar fiscal year and multiple classes of stock. If these exist, then only differences in voting rights are allowed. Something to keep in mind is that C corps do not have any restrictions on ownership like an S corp does. C corps can have multiple classes of stocks regardless of voting rights, and because of this, C corps do offer a bit more flexibility for a growing business with plans to expand ownership or even sell the corporation at a later date.
Can You Change Your Decision Later?
If you are not sure what your long-term goals are for the corporation, choosing between an S corp and a C corp can be a daunting task. You may be wondering if you can change the filing at a later date. The answer to that question is both yes and no depending on if you are willing to pay the corporate taxes on conversion from an S corp to a C corp. One thing to keep in mind is that if you choose to file your corporation as an S corp at your initial filing, then you never have to worry about the built-in gain tax on conversion. If you have chosen to file your corporation as a C corp, you can change it to an S corp at any time without paying this tax conversion.
You can also convert from an S corp to a C corp, but you will face a corporate tax if it was previously a C corp that elected S status within the past 10 years. If it has been at an S status for more than 10 years, you will not have to pay this additional tax upon conversion. If you want an S corp, it is always best to choose this when starting out so you can save yourself from paying the extra taxes at a later date when you convert.
How to Elect an S Corp
As mentioned, there is an extra step you must take if you want to elect the S classification for your corporation. You have 75 days from forming your corporation to file the S election if you want to avoid the additional corporate tax mentioned previously. The form you will want to file with the IRS is the Form 2553. The form can be complicated to understand because there is a time frame for you to submit it based on your tax year. If you want your election to be effective in the current tax year, then you must meet one of the following requirements:
- The official language states that it must be filed any time before the 16th day of the third month. If your corporation is a calendar year tax payer, then that means you must file the form by March 15th. If you file the form after this deadline, it will be effective for the next tax year. The only way around this is if you can show and prove that your failure to file on time was because of a reasonable cause.
- File at any time during the preceding tax year. Keep in mind that if you make an election later than two months and 15 days after the beginning of a tax year that is less than 2.5 months in length, it is still considered timely.
S Corp Election Form
One thing to keep in mind is that your state may require you to also file a state S corp election form after you have incorporated your business. You should check your local laws to ensure that you have filed all of the necessary documentation for both the IRS and your state and local governments.
Considering an S Corp
Taxes are a huge factor when choosing between these two types of corporations, but it is not the only thing you should consider. These are some of the reasons you may want to choose an S corp over a C corp. The first two are also benefits for choosing an S corp over an LLC.
- You want to be able to set salaries for both yourself as an owner and your employees as a way to minimize Medicare and Social Security taxes.
- You want to take advantage of pass-through taxation while still being able to take advantage of some benefits of a corporate business.
- You want flexibility in the type of accounting method you use within your business. Corporations are required to use the accrual method of accounting unless they meet the small corporation criteria of having gross receipts of $5,000,000 or less. S corps generally do not have to use the accrual method unless they have a small inventory.
- You want a lower risk of IRS audit exposure. S corps file an informational tax return (Form 1120), as previously mentioned, and there is a much higher audit rate on business income that is reported via Schedule C of Form 1040, which is the individual tax return. This takes some of the pressure off of the business.
Considering a C Corp
Just like there are specific reasons why you may want to choose an S corp over a C corp, there are some other advantages for choosing a C corp. These are just some of the reasons why you may consider it for your business structure:
- You want the earnings of the company to stay within the company so you can use it to grow the business.
- You want the flexibility to offer profit sharing to the owners of the company.
- You may want the option of venture capital for financing at a later date.
- You want the flexibility to distribute the earnings of the business between both the shareholders and the corporation for taxation purposes.
- You want to be able to provide health and medical benefits through the corporation. You may even want the flexibility to provide other benefit programs to employees such as life insurance, education, and even transportation costs.
- You want to be able to sell the business fairly easily, in terms of taxes and formation, at a later date.
- You want the flexibility to offer stock options to your employees.
- You expect the possibility of your corporation to own real estate at some point.
How to Make the Decision between the Two
There is no right or wrong answer when you are choosing between an S corp and a C corp. Both of these types of business formations have similarities that you can benefit from. Knowing the major differences can help you decide which one is best for you. For most small businesses, the double taxation for a C corp may not be a smart move, but there may be other components of a C corp that you require for your business. Since the main differences are the taxes of both, this is one of the main components you will want to pay attention to because it can make a big difference for the future of your business. If you are still unsure of which is the better option for your business, you should consult with a professional for advice.
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