The Difference Between C Corporations and S Corporations
The differences between a C corporation and an S corporation are fundamental, but these business structures share some common ground. For income tax purposes, corporations are separate from their owners, while S corporation owners pay the business income taxes. Confused? Here are the basics.
What Is a 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. Corporations can be sued separately from their owners, and the corporation 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. 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.
An S corporation is a subset of a corporation. First, a corporation must be formed, then S corporation status may be elected. The Internal Revenue Service (IRS) has specific requirements to qualify to elect S corporation status. The corporation must be a domestic (U.S.) corporation, it must have no foreign owners, it can have no more than 100 approved shareholders and can issue only one class of stock.
For tax purposes, an S corporation is considered a tax pass-through entity. The S corporation's shareholders only pay taxes on their allocated share of the income of the company, passed through to each individual shareholder on his or her personal tax return. Losses, deductions, and credits also pass through to the owners.
Differences Between C Corporations and S Corporations
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 against the corporation. Because the activities of the corporation are separate, its liabilities cannot be legally transferred to its shareholders.
The corporation's shareholders (owners) 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 his office.
Taxation draws the most definitive line in the sand between S corporations and C corporations. Shareholders in a regular or C corporation may receive dividends or shares of the corporation's revenue, and they may sell their shares for a profit or loss.
C corp 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 corporation files a tax return — Form 1120S — on which it shows its net profit or loss for the year, but 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. The S corp issues each shareholder a Schedule K-1, showing the amount allotted to him, and the shareholders must then report the income shown on the K-1 on their personal tax returns.
This profit or loss is added to their other income and deductions.
How to Decide Whether to Elect C Corporation or S Corporation Status
The decision to elect S corporation status for a corporation is an individual one. Many businesses elect S corporation status for their corporations for tax reasons, but there are other considerations. The conversion from a C corporation to an S corporation 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 a corporation and an S corporation, 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. Please discuss any decisions regarding your business status with both your tax professional and your attorney before making a decision.