Hi, I’m Priyanka Prakash, senior staff writer at Fundera.
One of the most common questions I see from small business owners is, what is the difference
between an S-corp vs C-corp?
The differences between S corporations and C corporations can have a big impact on your
tax bill and your bottom line, especially under current tax laws, so it's important
to know how they compare.
Let's cover the five main differences between an S-corp vs C-corp, starting with difference
number one: going public.
When you think of huge companies like Amazon, Facebook, and Walmart, these are all C-corporations,
and one of the main reasons they are is because they are publicly traded companies.
If you have plans to take your business public in the future, you should set your business
up as a C-corp because this business type has no limits on shares or shareholders.
You can have an unlimited number of shares, multiple classes of stock, and your shareholders
can be individuals, entities, US residents, or foreigners.
This kind of flexibility is very appealing to prospective investors.
An S-corp, on the other hand, is kind of like a miniature version of the C-corp.
You're limited to 100 shareholders with an S corp and only one class of stock.
Your shareholders can only be individuals or certain types of trusts or estates, but
no foreign individuals or entities can hold stock in an S-corp.
These limits can potentially be an obstacle for investors and prevent you from making
a big public offering.
The second big difference between S-corporations and C-corporations is taxes No surprise there!
The C-corporation is the only type of business entity that pays a business level income tax.
The corporate tax is currently a flat 21% for all C-corporations regardless of income.
On top of this corporate tax, however, shareholders also pay personal taxes on any dividends that
are distributed to them from the business.
Because of these two levels of taxation—once at the corporate level and again at the shareholder
level—you'll hear the word “double taxation” a lot in reference to C-corporations.
It’s certainly true that C-corporation income can be doubly taxed, but don't let this phrase
scare you off.
As we’ll explain more in a bit, there's a lot of income in a C-corporation that’s
actually exempt from taxation.
Now, S-corporations are pass-through entities, which means that the S-corporation itself
does not pay a corporate tax.
The business profits and losses in an S corp are reflected on the owners’ personal income
tax returns.
So, for instance, if you own 60% of an S-corp’s stock, you'll pay personal taxes on your 60%
share of the corporation's income.
You can also claim 60% of any credits or deductions that the business takes, and you'll have to
take the hit of 60% of the business losses.
There's no double taxation issue with S-corporations, which is why some small business owners prefer
it.
Under the current tax laws, pass-through entities, including S-corporations, can take a 20% deduction
of their business income before paying their taxes.
In a very simple example, if you have $100,000 of S corp income, you could deduct $20,000
and only pay taxes on the remaining $80,000.
Now, this is a very complicated provision of the tax code, and there are limits once
you reach higher business income levels or if you're in a professional service industry.
Still, despite these limits, many business owners find that they pay less in taxes with
an S-corp.
Difference number three between S-corps and C-corps has to do with certain types of tax
deductions.
C-corps have a sweet spot here.
Only C-corps can claim certain types of tax deductions and credits.
For example, C-corps are the only kind of business entity that can write off charitable
contributions as an ordinary business expense, though the contributions cannot be more than
10% of your total business income.
As another example, C-corporations can also deduct 100% of health insurance premiums and
other fringe benefits that are available to most employees.
In contrast, anyone who owns at least 2% of S-corp stock has to report fringe benefits
as ordinary income and pay taxes on those benefits.
Difference number four between C-corps and S-corps which a lot of people don't know about
is retained earnings.
Corporations are friendlier from a tax standpoint if you're planning to retain earnings in the
business rather than provide a lot of dividends.
Companies might choose to retain earnings to have an emergency fund, for instance, or
to save for big purchases such as equipment.
In a C-corp, shareholders only pay taxes on dividends, not on retained earnings.
Now, there is a limit on the amount of retained earnings a corporation can have, and it's
currently $250,000.
That limit is there so that corporations are encouraged to distribute some dividends to
shareholders.
However, as long as you're below that limit, retained earnings are tax exempt for a C-corp.
With an S-corp, owners have to pay taxes on their portion of business income, whether
it's retained in the business or distributed in the form of dividends.
The last difference we’ll cover between S-corporations and C-corporations is formation.
Whether you're forming an S-corp or a C-corp, you'll need to file articles of incorporation
with your state's business filing agency.
And once you do that, you'll need to take similar steps in both cases, such as writing
your corporate bylaws, appointing directors, and holding director and shareholder meetings.
Forming an S-corp requires one additional step, however, and that's filing Form 2553
with the IRS.
Okay, so now that we've covered the five major differences, which should you choose: an S-corp
or a C-corp?
There are a few different things to think through.
If you have plans to go public in the near future, then you should go with a C-corp because
that's what you'll need to get listed on an exchange, raise money from investors, and
offer your shares to the broader public.
Taxes is the other big consideration.
Many businesses end up saving on taxes with an S-corp due to that 20% business income
deduction.
But the tax differences really depend on how much money your business is making, what industry
your business is in, and what your business is spending money on.
For instance, if you're in a professional service industry, or if you retain more earnings
in the business, a C-corporation could be better for you.
This is where you actually should sit down with your accountant or tax pro and crunch
the numbers and see where you end up saving more.
In addition to all these differences that we've covered, there might be additional S-corp
versus C-corp differences for state level or local taxation.
If you have questions specific to your state or to your business, I recommend consulting
with a business lawyer.
We hope this was helpful and that you feel more confident in choosing between an S-corp
versus C-corp.
For more information on business entities and other small business insights, head over
to https://fundera.com/blog, and subscribe to our YouTube channel for
more videos.
Thanks everyone.