The primary differences between a C-Corporation and an S-Corporation are in the tax structure of the business. While there are some fundamental differences, these business structures also share some common ground. With S-Corporations, tax burdens will flow-through—pass-through—to the business partners. C-Corporations, on the other hand, will pay corporate tax and the individual partners will also pay income tax—if the business pays dividends to them.
What Is a C-Corporation?
Corporations—sometimes called C-Corporations" to distinguish them from S-Corporations—have been around since ancient times. The word comes from the Latin "corpus" or "body."
A corporation is a separate entity from its owners. There has been some controversy over the concept of the corporation as a legal entity, but that's the way corporations are treated for legal purposes in the U.S. Because they are a separate entity, corporations can be sued (separately from their owners), can make its own decisions, own property, and have assets and liabilities.
A corporation's owners are called shareholders or stockholders because they own shares of stock in the business. If the corporation is public, these shares will trade on a market. Private corporations—also called closed corporations—have shares held by a small number of owners or partners.
The activities of the corporation, including sales, revenues, expenses, assets, and liabilities, are legally segregated from those of its shareholders. A U.S. corporation is set up by registering with the state in which it's located, but creating an S-Corp requires an additional step.
What Is an S Corporation?
The term "S-Corporation" doesn't mean "small corporation." This type of business structure is named for Subchapter S of the Internal Revenue Code. An S-Corporation offers shareholders protection against the business's liabilities.
S-Corps are a subset of a corporation. First, a corporation must be formed, then the S-Corp status may be elected. The Internal Revenue Service (IRS) has specific requirements to qualify to elect this status using Form 2553. The corporation must
- Be a domestic (U.S.) corporation
- Must have no foreign owners
- Have no more than 100 approved shareholders
- Can issue only one class of stock
For tax purposes, an S-Corporation is considered a tax pass-through entity. The shareholders only pay taxes based on their allocated share of the income of the company. They report the passed-through income on their personal tax returns. Corporate losses, deductions, and credits also pass through to the owners. Also, even if the corporation did not pay dividends to the shareholders, they will still owe taxes based on their portion of the corporation's income.
Limited liability companies (LLCs), limited partnerships (LLP), sole proprietorships, and master limited partnerships (MLP) are all types of S-Corps.
A C-Corp is what you have if you do not elect S-Corp status with the IRS. Owners of C-Corporations and owners of S-Corporations have the same protection against lawsuits brought against the corporation. Because the activities of the corporation are separate, its liabilities cannot be legally transferred to its shareholders.
The corporation's shareholders cannot be sued on behalf of the corporation, nor are they personally responsible for debts it incurs. This separation is sometimes called a "corporate shield," but the shield can be pierced if an owner, board member, or executive acts outside the bounds of the law or the duties and responsibilities of their office.
Shares and Dividends
Taxation draws the most definitive line in the sand between S- and C-Corps. Shareholders in a regular or C-Corp may receive dividends or shares of the corporation's revenue, and they may sell their shares for a profit or loss. However, these owners have a double tax dilemma.
The corporation pays taxes on its profits and the owners are additionally taxed on the dividends they receive. Owners of a corporation who work in the business—typically in executive positions—are considered employees. They must be paid a reasonable salary and are also taxed on this personal income.
An S-Corporation does not pay dividends to its owners. The business files a tax return—Form 1120S—on which it shows its net profit or loss for the year. This amount is passed through to the individual shareholders and reported on their personal returns even if it is not actually received by the owner in the form of dividends. When the business passes through a loss, it becomes a deduction for the shareholder—up to the amount of their original investment.
The S-Corp issues each shareholder a Schedule K-1, showing the amount of profit or loss allotted to that individual. The shareholders must then report the K-1 income on their personal tax returns. This profit or loss is added to their other income and deductions.
Making the Decision
The decision to elect S-Corporation status for a business is an individual one. Many companies elect the S status for tax reasons. However, there are other considerations. The conversion from a C-Corporation to an S- can also be tricky and complicated. For example, converting the business property to the S-Corp has to be done carefully to avoid tax issues.
If you are looking at the tax differences between the two entities, consider whether you want to pay the tax personally or whether you want the corporation to pay the tax. If you work as an employee of the corporation, you must take a reasonable salary, so you will still have an income to be taxed.
If you are considering an S-Corporation election, get qualified opinions on all of the tax and other aspects and get help with the election filing. Discuss any decisions regarding your business status with both your tax professional and your attorney before making a decision.
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