Having the right corporate entity for your business can make the difference between significant profit margins and ending the year with a huge tax bill – or worse.
“My father, a business owner, didn’t have the proper guidance,” says Rachel Michaelov, CEO of Empire Tax Professionals, a company that helps business owners with bookkeeping and tax strategy. Michaelov shares that when she was 17 years old, her father went to jail for six months for not paying taxes. His tax liability at the time was $1.5 million due to not understanding which corporate entity to choose when setting up his business.
“I was confused, because my father was such a good business person,” she says. “It really hurt me.”
Michaelov went on to become an accountant because she didn’t want any other business owners to go through the pains her family suffered as a result of her father not understanding the financial and structural aspects of setting up a business.
Budding entrepreneurs’ primary focus tends to be on client acquisition and revenue generation. However, profit can dwindle quickly with a business structure that’s not optimized for tax consideration.
It’s important to know the difference between S corporations (S corps) and C corporations (C corps) as you set up your business. Here’s what you need to know about the differences between an S corp and a C corp, how to decide which business entity makes sense for you, and advice from three experts on the best way to set up a business with tax considerations.
C Corp and S Corp Defined
A C corp is the standard and default corporate business entity and structure, according to the Internal Revenue Service. It is a business entity with net income that pays taxes as a separate entity, has special deductions, shareholders, and officers, and distributes profit to its shareholders.
In contrast, an S corp is a pass-through taxation entity. This means that the tax burden is passed through to shareholders, who then report the income or loss on their personal tax returns. An S corp has officers and opportunities for special deductions.
A common point of confusion is whether or not S corporations are business entities. Technically, an S corp is a tax election for an existing entity. If you own a C corp, you could elect to have it taxed as an S corp using IRS Form 2553. But you can’t have your S corp be taxed as a C corp.
What Are the Differences Between an S Corp vs. C Corp?
In C corporations, corporate income tax is paid on the company profits. Shareholders of the corporation also pay taxes on profits from dividends earned or the sale of stock. This is called double taxation.
S corporations, on the other hand, are exempt from federal income tax. When your business structure has S corporation status, any income from dividends will be taxed at the individual level, and you’ll cover this when you pay personal income tax each year.
The differences are:
- The way tax is collected. Tax is paid on both the corporate and individual levels when you take money out of a C corp. You only pay taxes on a personal level in an S corp. Again, when you’re taxed as a C corp, you will encounter double taxation.
- Tax entity classification. A C corp is a separate taxable entity, while an S corp is a pass-through tax entity.
- The number of shareholders. A C corp can have an unlimited number of shareholders, while an S corp is limited to 100 shareholders.
- Shareholder restrictions. The shareholders of an S corp must be U.S. citizens or green card holders. Foreign nationals can start and/or become shareholders of a C corp.
- Type of stock. An S corp can only have one class of stock, while a C corp can have multiple classes of stock.
“One difference that is not often thought of and discussed is corporate ownership,” says Toni Moore, a business lawyer and generational wealth advocate for more than 20 years. “C corporations can be owned by a trust. That is something business owners should think about when estate planning. A C corporation being able to be owned by a trust is a benefit for those thinking about a succession and generational wealth plan.”
What Are the Similarities Between S Corp vs. C Corp?
When it comes to day-to-day operations, C corps and S corps operate in a similar way. The taxation is different, but both entities require filing articles of incorporation, and both entities will provide limited liability protection that helps keep your personal assets safe.
“One of the major similarities between an S corp and a C corp is the structure itself,” says Adrienne Gates, a tax expert and financial counselor. Both S corporations and C corporations have a board of directors, and both formation types let you to set your own ownership or shareholder structure.
The similarities are as follows:
- When setting up an S corporation or C corporation, you are required to file articles of incorporation with the state you’re setting up your business in.
- In both an S corp and a C corp, employees and officers need to be on the payroll.
- Shareholders own the corporation in both an S corp and a C corp.
- Both an S corp and a C corp have to abide by corporate formalities such as creating bylaws, issuing stock, and having shareholder meetings.
- The corporations need to maintain a registered agent, registered office, and file annual forms.
- An S corp and C corp offer legal protections for your house, your assets, and your savings against personal litigation.
How to Decide Between S Corporation vs. C Corporation
There are several factors to consider when deciding between an S corporation vs. a C corporation. It comes down to your goals, your business growth plan, and how you want to handle your personal income tax filings.
The right business structure reduces taxes and optimizes profit margins. To do that, choose a business entity that aligns with your future growth goals.
If you want to raise money at some point or grow a large company, you may decide to form a C corporation. If it’s not a goal to raise money or you have no desire to build the next Amazon, you may consider an S corporation. If you’re not a U.S. citizen or green card holder, your only option is to form a C corporation. Again, the main reason business owners choose to classify as an S corporation is to avoid double taxation.
“If you’re a small business that wants to save money on taxes, especially if your business is making more than $50,000 to $60,000 annually, an S corp is probably the entity you’ll choose,” says Michaelov. “You’ll also want to think about the type of deductions you’ll want to make.”
Other Alternatives To Consider
S corporations and C corporations aren’t the only tax entity options. Here are some of the simpler alternatives to be aware of:
- Sole Proprietorship. This is a business structure with no legal distinction between the business and the owner. That also means that all the liability falls on the business owner; if your business were to go bankrupt or be sued, your personal assets may be up for grabs.
- An LLC. A limited liability company allows you to start a business and treat yourself as the CEO of the business while also having personal liability protection. You don’t need to have a formal corporate officer structure with a limited liability company. You can elect to be taxed as an S corp with an LLC.
- A single-member LLC. A single-member LLC is recognized by the state and IRS as a company with one owner. The advantage to this structure is that if you choose to be taxed as an LLC, you can report your business income and expenses within your personal tax return instead of doing separate returns.
The entities mentioned above will also help you avoid double taxation. When it comes to deciding which business entity and structure would be right for you, it’s wise to seek help from a licensed professional. The information on business entities can be confusing, but to ignore it altogether can lead to real consequences.