Choosing the right structure is extremely important to your business, and it matters for asset protection purposes as well. Once you have decided to go with a corporation, you still need to decide whether you want to organize as a C corporation or an S Corporation. There are some important differences that you need to consider in making this decision. Knowing the similarities and differences of the structures can help you get the decision-making process started.
|Feature or Benefit
|Offers Limited Liability Protection
|Provides a separate Legal Entity
|Formation Requires Filing Articles of Incorporation
or a Certificate of Incorporation
|Required to Follow Corporate Formalities (such as annual
filing requirements and meetings)
|Separate Tax Rate (“Double Taxation”)
|Personal Income Tax is Due on Draws and Salary
|Must-Have Fewer than 101 Shareholders
|Can Issue More Than One Type of Stock
|Can Have Shareholders that are not US Citizens
|Shareholders Must Be Individuals
|Tax Deductible Fringe Benefits
|Works Well if Planning to go Public
|Works Well for Closely Held Companies
Similarities Between C Corporations and S Corporations
When most people think of corporations, the traditional C Corporation often comes to mind. However, an S Corporation has many of the same features and benefits as a C Corporation. For example, using this business structure creates a separate legal entity that offers you asset protection, regardless of whether the company is an S Corp or a C Corp.
Formation and Maintenance
Both entities are required to file Articles of Incorporation with the state in which they are incorporated. They must also follow corporate formalities such as issuing stock, adopting bylaws, holding annual shareholder and director meetings, and filing written reports with the state government and paying annual fees.
From a maintenance standpoint, S Corp and C Corps are remarkably similar. Failure to follow these corporate formalities may result in a dissolution of the business and could compromise your asset protection benefits.
Shareholders, Directors, and Officers
Owners of either an S Corporation or a C Corporation are referred to as shareholders. They hold specific portions of stock within the company. The shareholders must elect directors, who oversee business operations. Then, directors often hire officers, and these individuals manage the day-to-day activities of the enterprise.
Shareholders often wear more than one hat and fulfill many of these roles, particularly in smaller corporations. In fact, it is possible to form a corporation with just a single member. Usually, these individual member organizations are S Corps, but not always. Single-member corporations generally do not have the same concerns regarding asset protection that other single-member entities (like LLCs or sole proprietorships) may have simply because they are corporations.
Dividends and Salaries
Profits generally referred to as dividends, are distributed according to the number of shares each owner holds. These procedures are usually outlined in the corporate bylaws. Officers and directors often take a salary in addition to their dividends.
Differences Between S Corps and C Corps
While these two business entities have many similarities, they also have some key differences as well. Bottom line, these differences are what drives the decision to have an S Corp or a C Corp. They really only differ in two major areas: taxation and ownership.
Arguably the most important difference between a C Corp and an S Corp is that the two are taxed very differently. Most people who make the switch to an S Corp do so because they want to save money on taxes.
In a C Corporation, the profits of the corporation are taxed at the corporate tax rates. Corporate tax rates vary depending on how much money your business makes, but the highest rates in 2017 are roughly 39%. Personal service corporations use a flat 35% tax rate regardless of income. The highest individual tax rate is around 40%. Generally, corporate rates are lower than individual rates, but this is not always the case.
Once the corporation takes out its tax obligations from its profits, it then distributes any remaining revenue to its shareholders. Then, those shareholders are taxed at their regular individual rates. That means that every dollar that comes into the corporation is taxed twice before a shareholder can enjoy it. Assuming a 39% tax rate for both, that means that every dollar is really only “worth” about 37 cents.
Electing to become an S Corporation avoids this “double taxation” problem. S Corps are similar to LLCs in that they are “pass-through” entities. That means that the IRS treats an S Corp as if it were a sole proprietorship or partnership for tax purposes. Each dollar that passes through an S Corp is taxed as if it went to you directly. In our dollar example, the dollar in an S Corp is worth 61 cents compared to 37 cents in a C Corp.
Some states will still use double taxation, even if the business is organized as an S Corporation, so it is important to check with your state tax entity if you have questions about which tax arrangement will work best for you.
Other Tax Considerations
C Corporations may have other significant tax benefits, even if double taxation cannot be avoided. For example, only C Corporations can deduct fringe benefits from employees or officers. S Corporations do not have this benefit. While a fringe benefit deduction may not outweigh double taxation, it may help offset some of those costs.
Corporations may have losses that are not transferred on to the shareholders. This can be both a bad or a good thing. In an S Corporation, you can deduct these losses to decrease your overall taxable income. The same cannot be said about a C corporation. A C Corp can claim its own losses to reduce the corporate tax rate, but there is no direct benefit as there would be in an S Corp.
Ownership Restrictions and Limitations
If you are considering having your corporation “go public,” electing to become a C Corporation may be a good idea. You may not be able to avoid the double taxation issues, but you can have as many shareholders as you would like. This is not true of an S Corporation.
S Corporations are restricted to having fewer than 100 shareholders. The shareholders must also all be residents of the United States. They cannot be other businesses or trusts—they must be individuals. These restrictions do not apply to C Corporations. Shareholders in C Corporations can be LLCs, trusts, and even other corporations. They can also be foreign investors as well.
Limited Shareholder Rights
In a C Corporation, you can create various levels of stock. These different stocks can come with associated rights as well. For example, you may decide to form the preferred stock or differentiate between stockholders that can and cannot vote. Votes of some shareholders may not be “worth” as much as other shareholders. You can decide on a shareholder scheme that works for your particular business without worrying too much about restrictions.
You do not have the same flexibility in an S Corp. In fact, S Corps are limited to having only one type of shareholder. As a result, it is often much easier for C Corps to expand, sell shares, and attract investors.
Limitations on Earnings
S Corporations have limitations on how much they can earn as well. The IRS will automatically convert an S Corp to a C Corp if the company has accumulated earnings, passive investment income, and profits that exceed 25 percent of gross revenue for the prior three consecutive years.
The S Corp Election
To take advantage of the tax benefits of an S Corporation, you must file a form with the IRS to declare that you want to be treated as a pass-through entity. You must submit Form 2553 within certain deadlines to qualify for S Corporation status for that tax year. You can register anytime during the tax year before the election will take effect. However, if you cannot get the election done that quickly, you can also file before the 16th day of the 3rd month of the corporation’s tax year.
You may still be able to make the election if you have filed late, however. If you have reasonable cause or you inadvertently failed to file the form, and you would otherwise qualify as an S Corporation, then you may still be able to obtain the tax status. If the late-filed form is denied, then the tax status will apply in the following year.
When to Make the Decision
The form deadline means that you can be incorporated for several months without making a decision regarding whether to be classified as an S Corp or a C Corp. In addition, you can also transition to an S Corp at any time as long as you meet the requirements.
Shareholders can also voluntarily decide to revoke the S Corp designation at any time. Growth is usually the main reason that an S Corporation would want to convert, but there may be other reasons as well, such as the increased ability to attract investors with more flexible shareholder options.
The IRS can also revoke an S-corp election at any time if one or more of the eligibility requirements has been violated. Then, the business will automatically revert to C Corp status.
If you are still unsure about which status to use for your corporation, Protect Wealth Academy has an array of resources that you can use to help make this decision. Our video library features hundreds of hours of information about business formation and many other aspects of wealth management. Sign up for a free membership.