8/18/2020

Small Business Advice

C-Corporation vs. S-Corporation

Are you considering taking your business to the next level? Let's explore the pros and cons of C-Corps and S-Corps to see which one might be best for you.

Diana Helmuth

Marketing Manager

Sole proprietorships and LLCs are the most popular structures for newly founded businesses, but eventually, you may want to open your business up to bigger avenues.

If you’re just starting your business, and are only seeking liability protection, you’re still probably better off forming as an LLC, unless your accountant or lawyer tells you otherwise. This is because C-Corps and S-Corps are much more complicated and expensive than LLCs. In addition to more filing fees and documentation, both are required to have a structure of shareholders, board of directors, and managers. You will generally want to hire a lawyer to set-up and maintain the corporation, which is a significant expense. Furthermore, there’s a set of structural rules you must follow within a corporation, for example, holding at least one board of directors meeting every year, keeping track of company voting records, and having meeting minutes that can be reviewed. This is all for the purposes of transparency. 

For all these extra rules, most businesses only choose to incorporate as a C-Corp or an S-Corp to open the door to large rounds of outside investment, and eventually sell shares. If you feel your business is approaching that stage, or you know you eventually want to get there, let's talk about the major differences between C-Corps and S-Corps.

NOTE: All information below is state and industry specific, and for informational purposes only. Always check with your lawyer and accountant before making any decisions for your business.


C-Corp

Definition

A C-Corp is the default filing of a corporation. The “C” simply comes from the fact that this business entity is taxed under subchapter C of the Internal Revenue Code. The extra paperwork and structural requirements that come with incorporating as a C-Corp are typically only outweighed by the benefits of being able to get outside investment. In other words, being a corporation is probably something only to consider once you have a proven, stable business model with steady revenue, and you intend to get outside investors.

Pros

  • Unlimited ownership:  C-Corps don’t have many restrictions when it comes to ownership. Anyone can be an owner, including non-US citizens, and there can be as many owners as you’d like. If your goal is to take your company public, shares can be transferred freely between people and an unlimited number of times.
  • Larger funding options  Incorporating as a C-Corp is a sign of business legitimacy, and is seen by other businesses and banks as a signal that you intend to big, go public, or eventually be sold. You’re more likely to attract higher amounts of financing and, especially if you seek venture capital, a C-Corp is preferred over an S-Corp (chiefly because S-Corps are more difficult to sell and can’t be taken public).
  • Potentially More Tax Benefits: A C-Corp is not a “pass-through entity,” and is completely separate from its owners when it comes to taxes. While this turns into a recipe for “double taxation” wherein the business income is taxed, as well as any dividends shareholders personally receive from the business (which may be avoided by becoming an S-Corp), there are still a bevy of tax benefits available to C-Corps that can lessen your business tax burden. Under a new 2018 tax bill, the Corporate tax rate decreased from 35 percent to 21 percent, which is lower than the tax rate for LLCs and other pass-through incomes. Furthermore, C-Corps can write off many items LLC and S-Corps can’t, including the salaries of shareholders, medical premiums, and charity donations. C-Corps can also set their own fiscal years, meaning, shareholders can shift income more easily, ultimately deciding what year to pay taxes on certain things, and when to take losses, which can substantially reduce tax bills.

Cons

  • Obligatory structure: You can’t invent your own roles for everyone who works for your corporation. Instead, your structure must adhere to three traditional tiers of management: shareholders (the owners/those who hold stock in the company), directors (people directed by the shareholders to manage the business, set policy and make financial decisions) and officers (those managers elected by the board of directors to oversee day-to-day running of the business). So, unlike a sole prop, a corporation has a shared ownership structure, and is subject to the opinions of many. The idea is that if a single shareholder (including the CEO) leaves the company or sells their shares, the business can continue with little issue.
  • Double Taxation: Unlike sole proprietors, partnerships, and LLCs, C-Corps pay income tax on their profits. From there, individual shareholders are subject to personal income taxes on the dividends they are paid. Although double taxation is an unfavorable outcome, you do retain the ability to reinvest profits in the company at a lower corporate tax rate. It’s best to have an experienced corporate accountant on hand before you incorporate as a C-Corp.

S-Corp

Definition:

The “S” in “S-Corp” stands for “Subchapter S,” where the corp is taxed in the Internal Revenue Code. The biggest difference between an S-Corp and a C-Corp is that an S-Corp is a pass-through entity-- just like an LLC. This means that an S-Corp isn’t taxed on its profits, but passes them through to its owners.

Pros

  • Simpler taxes:  For many, this is the only reason to have an S-Corp instead of a C-Corp. Whereas a C-Corp, the business pays taxes on its income, S-Corps have no corporate tax to deal with before passing income onto shareholders. Instead, the shareholders report the company revenue as personal income. This avoids the C-Corp “double taxation” problem where both the corporation and individuals are subject to taxation. Most S-Corps can deduct up to 20% of their business income on their personal tax returns, and owners have the opportunity to write off business’s losses on their personal tax returns.
  • More owner control: S-Corps are limited to 100 owners, so transfer of ownership is often harder than with C-Corps. If your desire is to retain control of your business, and you want to make it more difficult to sell, this would be a better incorporation model upfront. However, like a C-Corp, you are still required to have a structure of shareholders, board of directors, and managers. Meeting minutes and voting records must be kept, and you must maintain the mindset of detailed transparency about how your business is conducted

Cons

  • Even more filings: Corporations require more state and federal formation filings than LLCs to begin with, and S-Corps require even more, beginning with Form 2553. Look to your state to determine what other fees you would need to pay, what documents you have to file, and where you will have to file.
  • Can’t go public and unlikely to be acquired: S-Corps are limited to 100 shareholders who must be U.S. citizens. This means that S-Corps can’t ever go public, as only 100 total people can ever hold shares in the company. Furthermore, since C-Corps have the ability to be owned by other types of companies, it makes being acquired by a separate company much more challenging if you are an S-Corp. The lack of ability to go public also typically discourages venture capitalists for investing in your business.
  • Unable to write off as many business expenses: Unlike with a C-Corp, S-Corps can’t write off charitable donations, medical expenses and retirement contributions. However, much of this can be accomplished on your personal taxes. It is recommended you hire an experienced accountant who can guide you through what is or is not possible with an S-Corp before you decide it's for you. S-Corps tend to be more heavily scrutinized by the IRS than C-crops.

Conclusion:

Both C-Corps and S-Corps are created through filing Articles of Incorporation and other documents in the state where it is formed (although you may notice, most Corporations are officially formed in Delaware, since they have the quickest and easiest process). Both must be structured to have directors, officers, and shareholders who function in the same manner. The owners (the shareholders) have the same protection from liability, and both signal to investors that you are open to larger rounds of funding than traditional SMB loans. The main difference is largely how you are taxed. As such, if you're debating between the two, its best not to incorporate as an S-Corp until you have an experienced accountant to help you with the process. Otherwise, the tax write-offs available to C-Corps, and the ability to signal to investors that you are open to larger investments, often make them the more common pick.


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