A corporation is one of the most popular business entity types. However, not all corporations are created equal.
There are two types of corporations: C corporations and S corporations. On the surface, the two corporation types may appear to have a similar structure, but in reality, they’re quite different from each other.
With this guide, we’ll cover the similarities and differences between C and S corporations, to help you decide which is right for your business.
What They Have in Common
All corporations, regardless of their designation, operate in a somewhat similar way.
For one thing, all corporations are groups of people operating together to accomplish the same business purpose, but in the eyes of the law, a corporation can operate as if it were an individual. As a legal “individual,” a corporation has the right to purchase and sell assets, enter contracts, hire employees, sue or be sued, and more.
In addition, corporations are the only entity type that can issue stock. Shares of stock allow shareholders to “own” a percentage of the corporation’s profits. In many cases, owning stock allows the shareholder to vote for the corporation’s board of directors.
The board of directors serves as the leadership for both C corporations and S corporations. The initial board sets up the bylaws which govern the entity, and all corporations must operate in compliance with their bylaws. Usually, you do not have to file these bylaws with your Secretary of State, but you are expected to have them. The directors also appoint officers to manage the day-to-day affairs of the business.
Both C corporations and S corporations start out the same way, by filing the articles of incorporation with the Secretary of State. S corporations require additional filings, however.
How They’re Different
The additional filings necessary to form an S corporation are not the only difference between C corporations and S corporations. To become an S corporation, an entity must already be incorporated, then the corporation can file IRS Form 2553 to apply to be an S corporation.
There are three key differences between an S corporation and a C corporation, which we’ll break down one by one.
The primary difference between C corporations and S corporations is how they’re taxed. C corporations face “double taxation,” which means that the corporation itself files a tax return and pays the appropriate corporate income taxes on its earnings each year.
The remaining income, after the corporation’s taxes and expenses, is then sent to shareholders in the form of dividends, and shareholders must pay taxes on those dividends on their personal income tax returns. As a result, the corporate income is taxed twice.
S corporations do not have such a hefty tax burden. By becoming an S corporation, the entity becomes a pass-through entity similar to a limited liability company (LLC). Pass-through entities do not pay taxes themselves — instead, the tax obligations “pass through” to the members of the business, who then pay taxes on that income on the individual level.
In this case, the members are the shareholders. Each shareholder reports his or her income from the corporation’s dividends on that year’s personal tax return, and those shareholders pay the usual personal income tax rate on that income. Under this system, S corporations only pay taxes once.
Number of shareholders
S corporations do receive a big tax advantage, but there is a drawback: S corporations may have no more than 100 shareholders, and every one of these shareholders must be a U.S. citizen or resident.
While this limit isn’t necessarily a problem for a small business, it does potentially limit growth opportunities from external investments.
C corporations, on the other hand, have no limit to the number of shareholders they can have. By issuing stock, a corporation essentially receives an investment from the person who bought the shares. In that sense, the corporation can raise a large amount of funds. Therefore, C corporations have higher taxes, but there is greater potential for growth through stock.
Classes of stock
In addition to the limited number of shareholders, the law places limits on the types of stock an S corporation can issue. Specifically, an S corporation may issue only one class of stock, whereas C corporations do not have that restriction.
Classes of stock allow a corporation to offer different voting options. For instance, you could have Class A shares, which provide the shareholder ten votes per share, and Class B shares, which provide the shareholder with just one vote.
Those numbers don’t need to be ten and one either — you can offer 25 votes for a Class A share and two votes for a Class B share, for example. The only uniform aspect of Class A/B shares is that Class A has more voting rights than Class B, although you can set up those votes in any ratio you see fit.
Which Type Is Right for My Business?
If you’re a relatively small business that meets the requirements listed above, you can consider becoming an S corporation, but is it the right choice for your business? That depends on a variety of factors. To decide, here are a few questions to consider.
First, what are your plans for growing your business? If you expect that your business will grow a lot in the next few years, then the shareholder restrictions of an S corporation might hold you back. On the other hand, if you don’t expect to exceed 100 shareholders, you may prefer the tax cut. An S corporation that grows beyond this scope can choose to revoke its tax status and revert to a C corporation as well.
In short, the debate between an S corporation or a C corporation boils down to one question.
Which matters more to you: saving on taxes, or getting investments from your stockholders?
If you’re not sure which choice is best for your business, you may want to talk with a tax professional or business analyst.
Professionals like these can help you predict the growth of your business, the potential impact of investments, and much more. Their expertise can help you determine which choice is best for your unique business.