C Corp vs S Corp
Learn about corporation types
What is C Corp vs S Corp?
Potential or existing business owners often face the choice of setting up either as a C Corp vs S Corp when starting a new business or changing their business structure. For everyone’s guidance, business goals primarily determine whether to incorporate as a C Corp vs S Corp.
Both corporation formats are governed by similar provisions regarding ownership and capital generation. They are separate legal entities that provide limited liability to owners. The major decisions are overseen by a board of directors, who represent the interest of shareholders, while the day-to-day operations are headed by an executive. The distinguishing features between C Corp vs S Corp are related to taxation and flexibility of ownership.
Summary:
- A C Corporation is the default designation provided to a freshly incorporated company.
- A corporation may choose to convert into an S Corporation at any point in time, given that it receives the consent of all its shareholders to file for S status.
- Both formats are governed by similar provisions regarding ownership and capital generation. The distinguishing features between the two formats are related to taxation and flexibility of ownership.
What are Corporations?
A business can be set up in multiple forms, such as a Limited Liability Partnership (LLP), Corporation, or Limited Liability Company (LLC). A corporation, by definition, is a type of business structure formed by filing a document called “Articles of Incorporation” with the state. Once set up under state law, a corporation becomes a separate legal entity, and its owners have limited liability for corporate debts.
Corporates must comply with a multitude of procedural rules such as paying annual fees, filing annual returns, issuing stock, holding general and shareholder meetings annually, and keeping minutes of said meetings. Non-compliance with the rules relating to the functioning of a corporation under U.S. corporate law may lead to the dissolution of the company or personal unlimited liability for its owners.
A C Corporation is the default designation provided to a freshly incorporated company. Any corporation may choose to convert into an S Corporation at any point in time, given that it receives the consent of all its shareholders to file for S status. The provisions allotting S status to companies are enumerated in Subchapter S of Chapter 1 of the Internal Revenue Code, which is where the term S Corporation comes from.
C Corp vs S Corp – Taxation
A traditional C Corporation is treated as a separate legal entity by the U.S. Internal Revenue Services (IRS). The business is charged corporate income tax for profits earned. The shareholders are liable to pay personal income tax on income earned from the company, i.e. profits earned in the form of dividends. This practice is often termed as “double taxation.” Certain fringe benefits provided for employee welfare such as healthcare and life insurance are deductible from corporate profits, which helps reduce the corporation’s tax burden.
Conversely, an S corporation does not get charged at the corporate level. All gains accrued by the business are attributed to the owners, who are then charged personal income tax. It resembles the model of a sole proprietorship or a partnership. An S corporation is not permitted to deduct the cost of fringe benefits offered, which means that they add to the taxable income of all shareholders holding more than 2% of stock.
C Corp vs S Corp – Flexibility of Ownership
An S corporation must not consist of more than 100 shareholders. To be eligible for ownership, one must be a natural individual holding a U.S. passport or be an American resident. This means that artificial entities such as trusts and other corporations are not entitled to ownership of stock in such a company. Each shareholder holds equal voting rights, as only one class of stock is permitted for distribution.
Certain types of business entities, such as banks and insurance companies, are not permitted to hold S status. C corporations, on the other hand, are permitted to list an unlimited number of shareholders. The shareholders’ voting rights may be divided to enable the implementation of various profit-sharing structures. Such a model is well suited for companies aiming to raise capital through complex vehicles such as initial public offerings (IPOs).
C Corp vs S Corp – Scale of Operations
The S designation is more suited to smaller or new firms that want to escape the double taxation effect employed by the C Corp structure. Most new firms expect to operate on losses for their initial years. The S structure is specifically advantageous as it allows owners to offset their income from other sources using the aforementioned losses, thereby reducing their overall tax liability.
Some states do not recognize S status, and converted companies, although recognized under federal law, may still be taxed under the C status structure. Thorough research about regional legislation must be conducted before alternating between business structures.
Related Readings
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:
