If you plan to incorporate your company, your business success might strongly depend on which corporate tax classification you choose. You have two options: an S corporation or a C corporation. The choice you make affects not just your business taxes but your personal taxes, business funding options, and ownership structure.
With all these considerations to keep in mind, how can you make the right choice when it comes to forming as an S corporation vs. a C corporation? Read on to learn more.
What is a C corporation?
A C-corporation, often called a C corp, is a corporate tax classification through which the company’s income is taxed separately from the owners’ and shareholders’ income. The company’s income is taxed at corporate tax rates, while the owners’ personal income is taxed at personal income tax rates. C corporations are the most common tax classification among corporations, though other business owners may opt to classify their companies as S corporations.
What is an S corporation?
An S corporation, often referred to as an S corp, is a corporate tax classification through which all the company’s income is passed on to the owners and shareholders and thus taxed as personal income. This structure, also known as a pass-through entity, means that an S corporation does not pay corporate tax. Instead, business earnings count toward the owners’ personal income, so an S corporation’s income is taxed at personal income tax rates.
How to incorporate your company
Whether you wind up going with an S corporation or a C corporation, your first step toward incorporating your business is filing articles of incorporation. In these articles, which you file with your state secretary’s office, you will likely need to include the following:
- The name of your company
- The name and address of your company’s registered agent, to whom all relevant communications are addressed
- The type of corporate structure, such as non-stock, nonprofit, or something else
- The names and addresses of each of your company's board of directors (a corporation must have a board of directors)
- The type and maximum amount of authorized shares you plan to make available to your company, such as common stock and preferred stock
- The duration of the business, if you do not plan for it to exist permanently
- The name, signature, and address of the company’s incorporator, which is usually the business owner (you)
- If a third-party is filing your articles of incorporation on your behalf, make sure they list your information
Some states may require additional information or not need some of the above information. Check with your incorporating state for details.
After your articles of incorporation are approved, your company is officially a corporation. Your next step is to choose whether an S corporation or C corporation is a better tax classification for your company.
The differences between S corporations vs. C corporations
While S corporations and C corporations are both corporate tax classifications, they differ in the following ways:
- Formation. If you incorporate your company, its default classification is a C corporation. You’ll need to take the extra step of filing IRS Form 2553 to classify your corporation as an S corporation.
- Taxation. An S corporation is a pass-through entity, meaning that its profits are passed along to its owners as taxable personal income. That’s why S corporation owners only pay taxes once, as personal tax. The business income of a C-corporation is taxed, so C corporation owners pay both personal and business tax.
- Tax forms. While both S and C corporations must file the quarterly IRS Forms 941 and 1120-W, their annual tax form obligations differ. C corporations must file IRS Form 1120, whereas S corporations must file the slightly different IRS Form 1120S.
- Shareholders. For an S corporation to have shareholders, it must be a domestic corporation that offers only one class of stock to at most 100 shareholders. C corporations have no such restrictions.
How to choose between an S corporation and a C corporation
Your choice of an S corporation vs. a C corporation depends on how the formation, taxation, and shareholder rules for these business entities will affect your operations. If you want to file one fewer formation document with the IRS and have unlimited shareholders, you might prefer a C corporation. If avoiding double taxation is of paramount importance to you, then you might want to register your company as an S corporation.
You should also consider how you plan to distribute your company’s profits and seek investors when deciding between an S corporation and a C corporation. The below pros and cons of each of these business entities will elucidate how you should address both of these considerations.
Pros and cons of S corporations
Registering your company as an S corporation comes with the following advantages and disadvantages:
Pros of an S corporation
- No double taxation. When looking at C corporation vs. S corporation taxes, an S corporation may seem more appealing. That’s because S corporations are pass-through entities, so their profits are passed along to owners as personal income. S corporation owners thus pay only personal income taxes, whereas C corporation owners pay both personal and business taxes.
- Business loss write-offs. If your S corporation experiences business losses, then you can deduct these losses from your personal income since your company is a pass-through entity.
- Qualified business income tax deduction. Under the Tax Cuts and Jobs Act (TCJA), eligible S corporation shareholders can deduct up to 20% of their net qualified corporate income from their taxable personal income.
- Better profit distribution to owners. Since an S corporation can have at most 100 shareholders, if your goal is to distribute your company’s profit among its owners rather than the public, an S corporation may allow you to do exactly that. Older businesses may be more interested in this profit distribution scheme than may newer ones.
Cons of an S corporation
- No public ownership. If your company is newer and wants to go public or invest its profits back into the company, the 100-shareholder limit of an S corporation may bar you from doing so. That’s because an initial public offering (IPO) is impossible with this shareholder limit.
- Less appeal to investors. Since S corporations are pass-through entities, investors may view them less favorably. With this negative perception comes fewer opportunities to acquire funding for your company.
- No preferred stock. In an S corporation, you cannot issue preferred stocks, which eliminate shareholders’ company voting rights while allowing them to receive dividends first.
- Limited ownership ability. Only individuals based in the U.S. can own S corporations. This too limits investor appeal, and it also limits the entities to which owners can sell shares.
Pros and cons of C corporations
Registering your company as a C-corporation comes with the following advantages and disadvantages:
Pros of a C corporation
- Simple application. Once you incorporate your company, that’s it – your business is a C corporation. You have no extra paperwork to file with the IRS.
- No stock and ownership limitations. A C-corporation can issue all kinds of stock to an unlimited number of all kinds of owners, including the public. This lack of limitations can be appealing for new companies looking to reinvest their profits back into the business.
- More appealing to investors. Since even other companies can own stock in a C corporation, registering your company as a C corporation opens your business to additional funding routes.
- Lower tax rates on business income. The TCJA lowered the corporate tax rate to 21% from its previous 35%. The corporate tax rate is thus significantly lower than the 37% maximum possible personal income tax rate. Since S corporation income is taxed as personal income, C corporations may offer their owners tax savings.
Cons of a C corporation
- Double taxation. Since C corporations are not pass-through entities, their owners are subject to double taxation: Once on their business income, and again on their personal income.
- No business loss write-offs. C corporation owners, unlike S corporation owners, cannot count business losses as personal tax write-offs.
- No qualified business income tax deduction. Although the TCJA substantially lowered the corporate tax rate, it only enacted the qualified business income tax deduction for S corporations. C corporation owners thus cannot deduct any of their business income from their taxable personal income.
- More formalities. A C-corporation’s articles of incorporation require it to include bylaws that create more formalities for a company. These formalities include annual shareholder meetings, committee formation, and more.
Why it’s important to choose the right entity
The importance of properly choosing between an S corporation and a C corporation comes down to ownership, age, and funding sources. Here’s why:
- Ownership: If you want your owners to include other companies or any foreign entities, you’ll need a C corporation. If your owners will be entirely U.S. based and plan to take out the company’s profits as distributions, you’ll need an S corporation.
- Age: Newer companies planning to grow rapidly may prefer C corporations since their stockholder options are virtually limitless. Older companies that want to distribute their profits among their shareholders may prefer S corporations.
- Funding sources: If you seek money from investors such as venture capitalists and other businesses, you’ll need a C corporation. These funding sources are impossible to acquire if your company is an S corporation – instead, you may fare better by turning to Small Business Administration (SBA) loans.
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