When it comes to starting your own business, you’re going to have to choose a business structure based on your company’s ideal tax situation. This decision is important, because it directly affects how much you’ll pay in taxes, your ability to raise venture capital, and your flexibility for growth in order to expand your business. In this article, our business attorneys will guide you through the differences between C-Corporations and S-Corporations and which business structure may be the right fit for your company. We will answer "What is an C-Corporation?", "What is an S-Corporation?", "What are the Differences Between S-Corporations and C-Corporations?" and discuss Which Corporation Form is Better for your business.
For more related information, see Corporations Explained.
What is an C-Corporation?
C-Corporations, or C-Corps, are the default type of corporations, as they are the most common type of corporation. C-Corps are taxed both at the corporate level and on the owner’s personal income tax returns, if the corporate income is distributed to the corporation’s shareholders as dividends. C-Corporations are ideal for raising venture capital, allow both U.S.-based and foreign shareholders, and have multiple classes of stock for an unlimited amount of shareholders.
Shareholders who have purchased stock in a company own the corporation, and those shareholders have limited liability protection, meaning they are not personally liable for the business’s debts or obligations. On the other hand, while they do own the business, C-Corp shareholders don’t make majority of the decisions. Important business decisions are left to the company’s shareholder-elected board of directors. Day-to-day operations are ran by the officers of the C-Corp – CEO, COO, CTO, etc. To structure your business as a C-Corp, you’ll have to file articles of incorporation with the Illinois state government.
What is an S-Corporation?
S-Corporations, or S-Corps, are considered “pass-through entities,” where a business’s profits and losses are reported on the business owner’s income. Similar to C-Corps, S-Corps also provide limited liability for shareholders; however, the owners of S-Corps can take advantage of pass-through taxation. Business owners can elect for an S-Corp by filing the IRS Form 2553. In an S-Corp, shareholders have to be U.S. citizens or residents, and there’s only one class of stock for 100 or fewer shareholders. An S-Corporation has similar documentation and compliance obligations as a C-Corporation, like filing articles of incorporation, issuing stock, and holding shareholder and director meetings. An S-Corp may choose to drop its S status and return to C status at any time, but the business has to wait five years to file for S status again. Learn how to form an S-Corporation in our other informative article.
What are the Differences Between S-Corporations and C-Corporations?
The main differences between S-Corps and C-Corps can be categorized into three areas: formation, taxation, and ownership. Here’s a breakdown:
Formation of a Corporation
The most basic difference between S-Corporations and C-Corporations are, obviously, formation. C-Corps are the standard type of corporation, so when you file articles of incorporation with the Illinois Secretary of State, your company will automatically become a standard C-Corp. To change this structure to S-Corp, you have to file IRS Form 2553, Election by a Small Business Corporation, no later than March 15th of the year your company is operating on a calendar year basis.
Taxation of a Corporation
Taxation is often the main motivator behind business owners choosing the S-Corps structure for their company. C-Corps are subject to “double taxation,” meaning they are taxed at both the corporate level and again on the owner’s personal income tax returns, if corporate income is distributed to shareholders as dividends. As a C-Corp, business owners can’t avoid double taxation unless they 1) don’t make any profits, or 2) reinvest profits back into the business instead of providing a dividend. Wages and salary, including the owner’s salary, are generally considered deductible expenses, so business owners don’t have to pay taxes on that. However, the IRS can “re-label” excessive salaries as a taxable dividend.
Paying taxes as an S-Corp is different. Shareholders receive pass-through taxation, meaning they report their share of the business’s income and losses on their personal tax returns. Owners only have to pay taxes at their personal income tax rate, so they aren’t subject to a corporate tax.
Ownership of a Corporation
Another major difference between S-Corps and C-Corps are the restrictions on corporate ownership. If a business owner wants to expand or sell his or her company at a future date, C-Corporations provide a bit more flexibility, because they do not have any ownership restrictions. C-Corporations also allow an unlimited amount of shareholders, as well as different classes of shareholders. Angel investors and venture capital firms prefer to hold stock in a corporation, which isn’t an option for S-Corps; therefore, it’s extremely difficult to fundraise investments for an S-Corp.
What are the Advantages of C-Corps?
- Easy to form: All corporations default to C-Corps, so there’s no additional paperwork to complete.
- Low cost of fringe benefits to employee shareholders: With a C-Corp, the cost of fringe benefits – disability, health insurance, etc. – can be deducted by the corporation, meaning they are not taxable to the shareholder, as long as the benefit is provided to at least 70% of the employees.
- Easy to raise investment money: C-Corps can issue multiple classes of stock to an unlimited number of shareholders, and investors face no liability for the corporation’s mistakes, making it much easier to invest.
- Shareholder flexibility: C-Corps can have an unlimited amount of shareholders in multiple classes of stock. They can also have foreign (non-resident alien) shareholders, which may be necessary to companies who aim to expand globally.
- Ownership flexibility: Other businesses can own C-Corps outright, which may be a benefit for companies looking to be acquired.
What are the Disadvantages of C-Corps?
- Double taxation: C-Corporations may pay more in taxes, because their revenue is taxed at both the corporate level and the personal level, if it’s distributed as shareholder dividends.
- No personal write-offs: Business owners aren’t able to write off the losses of the business in their personal income statements.
What are the Advantages of S-Corps
- Pass-through taxation: As we mentioned above, S-Corps do not have to pay taxes on the business’s income twice. Avoiding double taxation is the main motivation behind choosing an S-Corps for smaller businesses.
- Deduction of business income: S-Corps owners may deduct 20% of their business income on their personal tax return, which can significantly reduce their tax burdens.
- Tax filing requirements: S-Corps owners can also write off their business’s losses on their personal income tax returns, offsetting income from other sources.
What are the Disadvantages of S-Corps?
- Less flexibility: S-Corps cannot have more than 100 shareholders, issue more than one class of stock, have shareholders who are not U.S. citizens or residents, and be owned by C-Corps, other S-Corp, LLCs, general partnerships, or various trusts. This creates problems for businesses that expect rapid growth or want to conduct international business.
- Difficulty raising capital: Because there’s no hierarchy or difference between shareholders of the business, fundraising is extremely difficult.
- Difficulty to form: To elect S-Corp status, business owners have to file Form 2553 with the IRS and additional paperwork at the state level. They also have to make sure they stay within any restrictions in order to maintain S-Corps status and avoid penalties. The IRS tends to scrutinize S-Corps a lot closer than C-Corps. If you make a silly mistake, the IRS can terminate your S-Corps status and tax your business as a C-Corp.
Which Corporation Form is Better?
Typically, smaller businesses prefer S-Corporations due to the likely tax savings, and larger businesses prefer C-Corporations due to the flexibility of shareholders and stock classes and the ability to raise significant capital. S-Corporations are often not available to larger corporations, because they may require a lot of start-up capital and limit the opportunity to sell stock globally. If you plan to sell your business down the line or spin off a subsidiary, a C-Corp is probably a better choice. If you are looking for tax savings for a small business, an S-Corp is likely for you. Now that you understand the differences between C-Corps and S-Corps, you can make an informed decision. Only you know what’s best for your business.
Thanks for reading our article on the differences between c-corps and s-corps. We hope it provided some valuable insight into your business formation options. For more on other formation choices, see our article How to Form an LLC in Illinois.
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