To have a full grasp of the tax advantages of an S Corp and C Corp, you have to clearly define S Corp and C Corp.
What is an S Corporation?
An S Corporation which is referred to as Small Business Corporation is a business elected for S Corporation Status through the IRS. This business status allows the taxation of the company to be similar to a partnership or sole proprietor as opposed to paying taxes based on a corporate tax structure.
Please note that S corporations are taxed under Subchapter S of the Internal Revenue Code (IRC). As a corporation, an S corporation is created through filing Articles of Incorporation with the Secretary of State or a similar governing body.
It issues stock and is governed as a corporation, with directors, officers, and shareholders who function in the same manner as their C corporation counterparts. The owners (the shareholders) have the same protection from liability as shareholders of a C corporation.
An S corporation shareholder’s assets, such as personal bank accounts, cannot be seized to satisfy business liabilities. Nevertheless, just like a sole proprietorship or even a partnership, an S corporation passes most of its income and loss items to shareholders.
Unlike a regular corporation, there is no “double taxation,” meaning that the owners do not need to pay taxes twice – once at the corporate level and again on the individual shareholder level. Each shareholder is subject to his or her own individual tax rate on the profits and losses passed through to him or her, recorded as net income on the income tax return.
Table of Content
- What is C Corporation?
- Advantages of an S Corporation
- Disadvantages of an S Corporation
- Advantages of a C Corporation
- Disadvantages of a C Corporation
What is C Corporation?
A C corporation, under United States federal income tax law, refers to any corporation that is taxed separately from its owners. A C corporation is distinguished from an S corporation, which generally is not taxed separately. Many companies, including most major corporations, are treated as C corporations for U.S. federal income tax purposes.
C corporations and S corporations both enjoy limited liability, but only C corporations are subject to corporate income taxation. Corporations are formed under the laws of a state or the District of Columbia in the United States.
Procedures vary by state. Some states allow the formation of corporations through electronic filing on the state’s website. All states require payment of a fee (often under USD200) upon incorporation. Corporations are issued a “certificate of incorporation” by most states upon formation.
Most state corporate laws require that the basic governing instrument be either the certificate of incorporation or formal articles of incorporation. Many corporations also adopt additional governing rules known as bylaws.
Most state laws require at least one director and at least two officers, all of whom may be the same person. Generally, there are no residency requirements for officers or directors. However, foreign aliens have to form corporations via registered agents in many states as an obligation.
The Similarities Between S Corporation and C Corporation
It is important to state that under IRS rules, the C corporation is the standard (or default) corporation. The S corporation is a corporation that has elected a special tax status with the IRS and therefore has some tax advantages.
Both business structures get their names from the parts of the Internal Revenue Code that they are taxed under. C corporations are taxed under Subchapter C while S corporations are taxed under Subchapter S. To elect S corporation status when forming a corporation, Form 2553 must be filed with the IRS and all S corporation guidelines met.
Here are some of the similarities shared by both C corporations and S corporations:
Limited Liability Protection
Corporations offer limited liability protection, so shareholders (owners) are typically not personally responsible for business debts and liabilities. This is true whether it is taxed as a C corporation or an S corporation.
Separate Legal Entities
Corporations (C corps and S corps) are separate legal entities created by a state filing.
Formation documents must be filed with the state. These documents, typically called the Articles of Incorporation or Certificate of Incorporation, are the same regardless of whether you choose to be taxed as an S corporation or C corporation.
S corps and C corps have shareholders, directors, and officers. Shareholders are the owners of the corporation, but it is the corporation that owns the business. The shareholders elect the board of directors. The board oversees and directs corporation affairs and decision-making but is not responsible for day-to-day operations. The board elects the officers to manage daily business affairs.
The state corporation laws make no distinction between C corporations and S corporations when it comes to compliance responsibilities.
All corporations are required to follow the internal and external corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder and director meetings, maintaining a registered agent and registered office, filing annual reports, and paying annual fees.
The Differences Between S Corporation and C Corporation
C corps are separately taxable entities. They file a corporate tax return (Form 1120) and pay taxes at the corporate level. They also face the possibility of double taxation if corporate income is distributed to business owners as dividends, which are considered personal taxable income. Corporate income tax is paid first at the corporate level and again at the individual level on dividends.
S corps are pass-through taxation entities. They file an informational federal return (Form the 1120S), but no income tax is paid at the corporate level. The profits/losses of the business are instead “passed-through” to the business and reported on the owners’ personal tax returns. Any tax due is paid at the individual level by the owners.
Personal Income Taxes
With both C corporations and S corporations, personal income tax is due both on any salary drawn from the corporation and any dividends received from the corporation.
As stated earlier on, state corporation laws make no distinction between S corporations and C corporations. But the Internal Revenue Code does place several restrictions on who can be shareholders for the corporation to qualify to be an S corp.
S corps are restricted to no more than 100 shareholders, and shareholders must be US citizens/residents. C corporations have no restrictions on ownership.
S corporations cannot be owned by C corporations, other S corporations (with some exceptions), LLCs, partnerships, or many trusts.
S corporations can have only one class of stock (disregarding voting rights), while C corporations can have multiple classes.
Advantages of an S Corporation
- The major advantage of the S corporations over the C corporations is that an S corporation does not pay a corporate-level income tax. In essence, any distribution of income to the shareholders is only taxed at the individual level.
- 20 percent qualified business income deduction
- The Tax Cuts and Jobs Act of 2017 gave eligible S corporations shareholders a deduction of up to 20 percent of net “qualified business income”.
- Pass-through of losses
- The losses of an S corporation pass through to its shareholders, who can use the losses to offset income (subject to restrictions of the tax law).
Disadvantages of an S Corporation
- A limited number of shareholders
- An S corporation cannot have more than 100 shareholders, meaning it can’t go public and limits its ability to raise capital from new investors.
Other shareholder restrictions
- Shareholders must be individuals (with a few exceptions) and U.S. citizens or residents. This also makes it harder for an S corporation to obtain equity financing, particularly because venture capital and private equity funds tend to be ineligible shareholders.
- Preferred stock is not allowed
- To be eligible for S corporation status the corporation cannot have different classes of stock. Some investors want preferences for distributions or other privileges. An S corporation cannot provide that.
Most S corps will restrict their shareholders’ ability to sell or transfer their shares. That’s to make sure they don’t end up with an ineligible shareholder which will cause the IRS to terminate its S corporation status. This makes it harder for the shareholders of an S corporation to exit the corporation.
Advantages of a C Corporation
- An unlimited number of shareholders: There is no limit on the number of shareholders a corporation taxed under Subchapter C can have.
- No restrictions on ownership: Anyone can own shares, including business entities and non-U.S. citizens.
- No restrictions on classes: A C corporation can issue more than one class of stock, including stock with preferences for dividends and distributions.
- The lower maximum tax rate: The 2017 tax reform act lowered the corporate tax rate to a flat 21 percent and eliminated the alternative minimum tax. Even with the personal income tax rates being slightly lowered, this rate is lower than the maximum personal tax rate (which is currently 37 percent).
- More Options for Raising Capital: Because Subchapter C of the tax code does not impose the same restrictions on ownership as Subchapter S, it is easier for a C corporation to obtain equity financing.
Disadvantages of a C Corporation
- Double taxation: The main disadvantage of the C corporation is that it pays tax on its earnings and then shareholders pay tax on dividends, meaning the corporation’s earnings are taxed twice.
S Corp Vs C Corp Tax Advantages: A Detailed Comparison
The provision of the law of the United States allows taxpayers to form tiers of corporations with an S corporation owning the stock of C corporations when the individual shareholder does not wish to directly own the C corporation stock.
Also, when a shareholder for nontax reasons wishes to form several S corporations (the shareholder wants each business to be separate for liability reasons), he or she no longer must own all the stock directly and file separate income tax returns for each corporation.
The taxpayer can cause one S corporation to own all the stock of the other S corporations and treat the subsidiary corporations as QSSSs. This would allow the parent S corporation to file just one income tax return—thereby reducing administrative costs and burdens. Before deciding on such an organizational structure, however, the state tax implications should be examined.
Please note that under IRS notice 97-4 (IRB 1997-2), when the parent corporation makes the election, the subsidiary is deemed to have liquidated under IRC sections 332 and 337 immediately before the election is effective. Such liquidations generally are nontaxable.
When a corporation liquidates under section 332, that corporation must file Form 966, Corporate Dissolution or Liquidation, within 30 days of the adoption of the liquidating plan or resolution. In addition, the corporation must file a return for the short period ending on the date it goes out of existence.