S Corp vs C Corp: What’s the Difference?
S vs C corp – which one is right for your business? There are many different types of business entities, and it can be confusing to determine which is the best fit for your company. In this blog post, we will compare and contrast S corp vs C corp. We’ll outline the benefits and drawbacks of each, so you can make an informed decision about which type of corporation is right for you. Let’s get started!
What Is C Corporation?
C corporations (or C-corps) are corporations organized under the tax code so that their stockholders do not pay corporate taxes. The most common type of corporation, “C” corporations, must also pay taxes on their profits. In a situation of “double taxation,” a company’s profits are subject to taxation at the corporate and individual levels. When a company receives the C-corp status from the IRS, it must file a federal tax return (Form 1120) to pay corporate income tax. Any profits from dividends must be reported by shareholders and taxed as individual income.
Advantages of C Corporation
Since a company operates independently of its shareholders, it is responsible for its financial commitments. When dealing with a corporation, creditors must look to the firm itself to pay off debts, not the owners. Shareholders’ risk is capped at their initial investment in the company.
Low tax rates
The C corporation is an unusual but viable option for small businesses. In this way, a company that is not a public service corporation might save money on taxes while amassing cash for use in financing accounts receivable, inventories, and fixed assets. Capital gains and FICA are taxed at the individual’s marginal tax rate in an S corporation, LLC, partnership, or sole proprietorship. A C company can save a lot of money on taxes up front, making it easier to raise money for business expansion if its taxable income is kept below $75,000.
What’s the difference between s corp and c corp in terms of fringe benefits? Compared to unincorporated businesses and S corporations, C corporations have the advantage of being able to deduct the cost of fringe benefits (such as group term life insurance, health and disability insurance, death benefits payments up to $5,000, and employee medical expenses not covered by insurance) from their taxable income. Employees who are also shareholders do not have to pay taxes on any fringe benefits they get.
Unlimited growth potential
The maximum number of shareholders in a C Corp is unrestricted, unlike in the case of an S Corp. Additionally, there is no cap on share sales. Also, there is no limitation on the type of entity that can be a shareholder or the country of origin of its shareholders. Raising equity capital is easier than with an S-corporation or other business formations.
The term “perpetual existence” describes a corporation’s ability to continue existing even after its shareholders die. It’s common knowledge that the death of a sole proprietor means the company’s end. In the case of a corporation, however, this is not the case. Unless otherwise stated in its articles of incorporation, a corporation remains in existence from the time it is founded until it is dissolved, wound up, and liquidated. Furthermore, the stock transfer does not affect the company’s continued existence.
Disadvantages of C Corporation
C corporations pay a tax on their retained earnings after deducting operating costs like employees, fringe benefits, and interest. When shareholders get a portion of a company’s profits in the form of dividends, they must report and pay tax on that income. In some cases, double taxation may not be a significant detriment to businesses if they plan to reinvest most of their revenues back into the company. Since most or all of a small business’s profits go toward salaries and fringe benefits, both of which are tax-deductible, the business may be able to avoid paying taxes twice on its earnings.
Bureaucracy and costs
Since corporations are separate legal entities from their owners, they must follow different state and federal laws, some of which can be hard to understand. Therefore, it will be necessary to retain the services of attorneys and accountants, schedule and hold regular meetings of the board of directors and stockholders, and meticulously record the proceedings of these gatherings. Any corporate action needs to be approved by the board of directors, which can make it take longer for the company to respond to emergencies. When forming a corporation, filing fees must be paid to the appropriate authorities. In addition, a company needs an attorney to file a case in small claims court, but an individual or business partnership can do so without one. In addition, the company must pay taxes in other states where it operates because it is considered an “out-of-state” firm.
Profits in a corporation are distributed to shareholders in proportion to their ownership stake, but in a partnership, profit distribution might take into account either partners’ capital contributions or their roles as business employees. Yet, in some areas, the amount of a corporation’s dividend payout is limited by law. A company usually needs to have no outstanding expenses for directors to issue a dividend. In most states, directors can be held personally accountable to creditors if they fail to do so and the distribution of dividends threatens the corporation’s financial viability.
No Deduction of Corporate Losses
Unlike shareholders of an S Corp, those of a C Corp are not allowed to write off business losses on their tax returns.
What Is S Corporation
According to the Internal Revenue Service, an S corporation (or “S corp”) is a business entity allowed to distribute its taxable income, credits, deductions, and losses to its shareholders. That sets it apart from the typical C corp in important ways. The S corp is an alternative to the LLC that is open only to companies with 100 or fewer stockholders (LLC).
S corporations and limited liability companies (LLCs) are considered “pass-through businesses” since they are exempt from paying corporate taxes and instead distribute profits to their owners. The designation of S corporations for tax purposes is found in subchapter “S” of the Internal Revenue Code, hence the name “S-corporation.”
Advantages of S Corporation
The federal government does not tax an S corporation. Most states adhere to federal guidelines, but not all. The company’s “pass-through” status means its owners must include their portion of its profits or losses on their tax filings. This means that shareholders can reduce their taxable income by the amount of their share of the business’s losses. This can be a huge boon in the early stages of a company’s development. Companies that fail to convert to S corporations risk being labeled as “personal holding companies” if they amass significant amounts of passive income.
The owners’ assets are shielded from business liabilities under an S corporation. The assets of a shareholder are not at risk because of the company’s debts and liabilities unless the shareholder has given an explicit personal guarantee. Shareholders’ homes, bank accounts, and other personal property are off limits to creditors seeking payment for business debts. Owners and the company are treated as one in a sole proprietorship or general partnership, which might put owners’ assets at risk.
Tax-favorable characterization of income
Shareholders in an S corporation can receive employee benefits and compensation. Dividends and other payouts from the corporation are tax-free up to the amount of the shareholder’s investment in the corporation. Properly characterized distributions can minimize the owner-self-employment operator’s tax burden as compensation or dividends. At the same time, the business still benefits from the deductions for business expenses and wages paid.
Direct ownership transfer
The transfer of ownership in an S corporation results in no taxable income to the shareholder. When an ownership stake is transferred, the S company is not subject to complex accounting procedures or required to make adjustments to the property basis.
Unlike a sole proprietorship or partnership, an S corporation shows potential clients, workers, and suppliers that the business’s owners mean business.
Disadvantages of S Corporation
Increased IRS scrutiny
The Internal Revenue Service (IRS) reviews dividend and salary payments to ensure they accurately reflect the nature of the money given to shareholders. Since dividends can be reclassified as wages, the company may lose its deduction for labor paid. On the other hand, if dividends are changed to wages, the company may have to pay employment taxes.
Formation and ongoing expenses
To start a business as an S corporation, you need to get your firm incorporated by submitting Articles of Incorporation to the relevant state, getting a registered agent, and paying the necessary costs. Furthermore, annual reports and franchise tax costs are imposed by several states regularly. A sole proprietor or general partnership will not have to pay these costs, though they are typically low and can be written off as a normal operating expense.
Tax qualification obligations
Accidental loss of S corporation status and conversion to a Subchapter C taxpaying organization can occur if the necessary steps are not taken about the election, consent, notice, stock ownership, and filing requirements. Even though it doesn’t happen often and the solutions are usually easy, this problem doesn’t happen with other pass-through tax categories.
Stock ownership restrictions
Although an S corporation can issue voting and nonvoting shares, there can be only one class of stock. For this reason, it is impossible to have distinct types of shareholders with varying dividend and distribution rights. In addition, the number of stockholders is capped at 100. In addition to being restricted from ownership by trusts and other corporations, foreigners are not allowed to have any stake in the company.
Less leeway in profit and loss distribution
An S corporation can only have one class of stock. Therefore, its profits or losses cannot be distributed to individual investors. Unlike partnerships or LLCs taxed as partnerships, where the division of income and loss can be established in the partnership agreement or operating agreement, stock ownership determines how a corporation’s profits and losses are distributed. (Note that stockholders in C corporations typically cannot deduct losses unless their stock is worthless or sold at a loss.)
Which Is Best for You?
C corporation vs S corporation – there is no optimal choice that can be applied to a company. When starting a business, owners should talk to legal and tax experts to make smart decisions about whether to incorporate or register their business, depending on the specifics of their business. However, it’s important to be familiar with the key differences between s corp and c corp and remember that many firms transition from one form to another as they develop and expand.