- What are Business Entities?
- What are C and S Corporations?
- What are the Benefits of Being a C Corporation
- What are the Drawbacks of Being a C Corporation?
- What are the Benefits of Being an S Corporation
- What are the Drawbacks of Being an S Corporation?
- Which is Right for Your Small Business?
- Final Thoughts
There are a few different ways you can structure a new business as a startup. There are sole proprietorships, which are owned and operated by a single person. There are limited liability companies, which limit the risk of losing personal assets over business matters. And then there are corporations, which are divided into C and S corporations. While both forms of corporations have a few things in common, you should know the difference between these two structures before you set your articles of incorporation in stone.
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When you first start your company, you’ll need to decide how it should be structured. There are a number of factors that go into business structure. You’ll need to consider how many people have ownership of the company. You’ll want to think about your future plans. And you’ll want to think about your personal liability.
The exact structure of your company will vary depending on the complexity of the team, the number of people involved, the state you’re operating in, and several other factors. But when it comes down to it, you choose the structure you choose because of business taxes. How do you want to pay taxes?
- In a sole proprietorship, the company’s taxes are paid as personal income tax. If you go down to your street corner and set up a food truck selling sandwiches, you’re setting up a sole proprietorship. You don’t have a salary, and no one else is using the profits. You’ll just pay taxes on the money you make.
- A partnership is a slightly more complex tax status than a sole proprietorship. If you and a buddy set up that food truck, you’re now operating a partnership. The same rules apply above – you’ll pay your company’s taxes on your personal tax returns. But partnerships are by their very nature more complex than sole proprietorships. Do both partners own 50% of the company? Is it 60/40?
- A limited liability company, or LLC, is a designation not technically recognized by the IRS but provides lots of flexibility. An LLC can choose whether to be taxed as a sole proprietor, an S corporation, or a C corporation. LLCs are one way to make S corporations a bit more flexible, as S corporations are limited to 100 shareholders, one of which can be an LLC made up of multiple people.
And then there are corporations, which take the form of either a C or S corporation.
The exact structure of your company will vary depending on the complexity of the team, the number of people involved, the state you’re operating in, and several other factors. But when it comes down to it, you choose the structure you choose because of business taxes. How do you want to pay taxes?
- In a sole proprietorship, the company’s taxes are paid as personal income tax. If you go down to your street corner and set up a food truck selling sandwiches, you’re setting up a sole proprietorship. You don’t have a salary, and no one else is using the profits. You’ll just pay taxes on the money you make.
- A partnership is a slightly more complex tax status than a sole proprietorship. If you and a buddy set up that food truck, you’re now operating a partnership. The same rules apply above – you’ll pay your company’s taxes on your personal tax returns. But partnerships are by their very nature more complex than sole proprietorships. Do both partners own 50% of the company? Is it 60/40?
- A limited liability company, or LLC, is a designation not technically recognized by the IRS but provides lots of flexibility. An LLC can choose whether to be taxed as a sole proprietor, an S corporation, or a C corporation. LLCs are one way to make S corporations a bit more flexible, as S corporations are limited to 100 shareholders, one of which can be an LLC made up of multiple people.
And then there are corporations, which take the form of either a C or S corporation.
What are C and S Corporations?
C and S corporations are both types of business entities that provide liability protection for their owners. By establishing a corporation, business owners can protect their personal assets from forfeiture in the event of debt default or a lawsuit against the corporation.
To create a corporation, you’ll need to file several forms with government entities. In particular, you’ll need to file articles of incorporation with your state’s Secretary of State. All corporations are initially created as C corporations, but you can file IRS Form 2553 to become an S corporation.
Both corporation types will use Form 1120 to file federal income taxes, but S corporations will file Form 1120S, a slight variation. That’s because under the Internal Revenue Code’s Subchapter S, there are rules that create a huge advantage for S corporations.
S corporations are the most common corporate structure in the U.S. because of their tax advantages. The reason why is simple: double taxation. Profits from an S corporation are “passed through” to individual shareholders who pay personal income tax on their portion of that business income.
C corporations, however, pay corporate tax as a separate legal entity from their owners. That means that when the business owners receive a salary or dividends (or both), they are paying income taxes on that money on top of the taxes paid at the corporate level.
There are a few additional differences between the two classes of corporations, discussed below, but for tax purposes, that’s the most important one.
What are the Benefits of Being a C Corporation
C corporations are great when you plan on massively expanding your business. That’s because they allow for an unlimited number of shareholders and different types of shareholders at that. If you want some stock to come with additional dividends, you can do that. If you want to sell preferred stock to a foreign investor, you can do that.
You can also sell as many shares as you’d like to investors. If a group comes to you and wants to purchase a considerable amount of equity, you’re not encumbered by a limit in shareholders like you are if you’ve got S corp status.
On top of that, depending on where your corporation is operated, you might find that local tax laws mean that you’re paying the corporate tax rate is cheaper than paying federal income tax on passed-through profits. According to The Tax Foundation, Nevada, South Dakota, and Wyoming, all have no corporate income tax whatsoever, while operating a business New York means looking at a corporate tax rate of over 7%.
In short, if you’re looking for limited liability, the ability to grow massively and seek external funding, and want to ensure that there are multiple classes of stock, C corporation status is likely the right business structure for you.
What are the Drawbacks of Being a C Corporation?
C corporation status has a ton of benefits, as we can see. There are drawbacks too. The accounting process can be very complex for C corporations due to the large number of parties involved at different levels of stock. But for small business owners considering this path, the biggest downside is that double taxation. Many of the benefits of being a C corp are derived from the freedom to grow large, raise lots of outside capital through equity, and limit personal liability. Being taxed at both levels, corporate and personal, is what you trade for that freedom.
The other downsides of C corporation status also stem from the lack of pass-through status. If an S-corporation takes a loss in a year, its shareholders are able to write that loss off on their personal income tax, creating some protection from extra tax liability. Because C corporations pay taxes at the corporate level, they also write losses off at the corporate level. There’s no benefit passed through to shareholders, either.
The other downsides of C corporation status also stem from the lack of pass-through status. If an S-corporation takes a loss in a year, its shareholders are able to write that loss off on their personal income tax, creating some protection from extra tax liability. Because C corporations pay taxes at the corporate level, they also write losses off at the corporate level. There’s no benefit passed through to shareholders, either.
What are the Benefits of Being an S Corporation
S corporations have a few advantages. For one, they’re the simpler type of corporation. S corps can only have a single class of stock and there’s a limit of 100 shareholders. If your company is an S corporation, it can’t go public, and there’s a firm limit to your ability to raise external capital and you may need to rely more on long-term loans and other debt-based forms of funding.
However, when it’s tax time an S corporation distributes profits to those shareholders and that’s when taxes are paid, and just once. If there are four stockholders, each holding 25% of the company’s stock, then each stockholder will claim 25% of the company’s profits on their income tax returns and pay federal taxes on that money on the individual level, subject to their own personal income tax rate. So you pay taxes just once while also receiving the liability protection that comes with having a corporation as a separate entity.
On top of that, the Tax Cuts and Jobs Act of 2017 contained a provision allowing certain entrepreneurs to take a 20% deduction of qualified business income. That means that for qualifying business owners, you’re not only saving tax dollars by passing through profits, but you’re also then able to write a further fifth of that profit off.
What are the Drawbacks of Being an S Corporation?
The ways in which a C corporation is set up for long-term wide expansion reflect some of the drawbacks of S corporation status.
An S corporation has firm limits on shareholders. They can only have 100 total shareholders, all of whom must be U.S. citizens and all of whom receive the same class of stock. There’s no preferred stock or another way of differentiating.
Those limitations can make equity financing more difficult. An S corporation can’t receive international funding, and with a limit of 100 shareholders, there’s a strict limit to any venture capital it can receive. If you’re creating a type of business that might rely on foreign investment, you may want to keep that in mind.
Which Is Right for Your Small Business?
So which corporate structure is right for your company? That depends on your plans on a few features of each type of corporate structure.
Do you plan to seek external investment? If you’re looking to raise external money from a wide variety of investors, a C corporation is probably the right call, as the 100-shareholder limit will
Are you comfortable with double taxation? The tax benefit that comes with pass-through status means that having your company structured as a c corporation lessens your tax burden. If you’re looking to maximize tax savings, you may want to consider a different entity type. S corporation profits are only taxed on the personal level.
Do you plan on an IPO? If you’re thinking five, or ten years down the line and may want to consider making your company public, you’ll want to avoid the S corporation structure, as you’ll be limited to 100 shareholders.
How complex is your ownership structure? If your company is structured around a few owners willing to make things a simple split, an S corporation might be the right move. After all, profits distribution is done according to the percentage of shares held, and all shares are worth the same. If your company’s ownership group is more complex, a C corporation allows you the most flexibility.
Final Thoughts
At the end of the day, choosing your status, S corp vs. C corp, comes down to how you prioritize several aspects of your company. If you value the freedom to grow into a massive, international company that goes public, you will want to steer clear of S corp status. And if the idea of double taxation isn’t something you’re comfortable with, you should go that way.
But you should also remember that your choice isn’t necessarily permanent. If you choose C corp status and find that you still fit the qualifications for S corp status, you can absolutely make that change. And vice versa – if you want to accept foreign investment or IPO as an S-corp, you can make the change to C.
