When setting up their business, many entrepreneurs balk when given the option to choose between S-Corp vs C-Corp. Young business owners also fail to recognize the similarities and differences between the two, and how picking one over the other could benefit both them and their business.
Fundamental Differences Between C-Corps and S-Corps
When making a decision between C-Corp vs S-Corp, it’s essential that new business owners understand the structural differences between the two choices. Most new businesses who elect corporation status are considered to be a C-Corp. C-Corps are known as “regular” corporations. The only reason they have the “C” in front of their name on federal and state documents is to help distinguish them from S-Corps. S-Corps, on the other hand, refer not to the corporate structure of the business, but as how the company files their taxes with the IRS. Once established as a corporation, owners have the option to file their taxes as a S-Corp.
There are strict criteria about the ownership requirements for S-Corps vs C-Corps. Owners of an S-Corp cannot be nonresident aliens. Meaning, they must be either a U.S. citizen or a resident alien. C-Corps, on the other hand, do not have such stringent requirements. Not only can nonresident aliens be a part of a C-Corps ownership structure, but other entities can as well, including
- Foreign businesses and companies
Furthermore, S-Corp ownership is capped at 100 shareholders. C-Corps, on the other hand, can have an unlimited number of shareholders. For many small business owners in the United States, their ownership group may only consist of themselves and a few others. If these people are all U.S. citizens or residents, they could potentially find it worth their while to opt into S-Corp status as opposed to maintaining their official C-Corp status. Business owners can choose to file for S-Corp status any time after they have incorporated, so this is not a decision that you must make immediately.
Tax Differences Between C-Corps And S-Corps
In addition to the structural differences between C-Corps vs S-Corps, there are also some significant differences in how these entities are taxed. Understanding the differences in taxation methods could help business owners decide whether they would like to maintain their C-Corp status or opt into S-Corp status. S-Corps allow business income and expenses to pass through to Shareholders personal tax returns. The “pass-through” occurs before the income and expenses are taxed at the corporate tax rate.
When filing as a C-Corp, businesses are subject to double taxation because the IRS views the corporation as a separate taxpayer. This means that not only is all income subject to taxation, but profit distributions to the company’s shareholders are also subject to taxes. The IRS views these payouts the same as they do dividend payments. The business cannot deduct profit distributions from its corporate tax return.
The main difference, therefore, can be seen in the personal tax rate versus the corporate tax rate. If a business owner is taking on much of their company’s income onto their personal tax return, then they could be in a very high personal tax bracket. The rate at which they pay their personal taxes could be much higher than the corporate tax rate. This could be particularly true under the new Tax Cuts and Job Acts, which Congress passed in late 2017. That’s because starting with 2019 tax filings, which are reflective of the 2018 business year, the corporate tax rate for C-corps has been slashed from 35% to 21%. Companies who may have once benefitted from a S-Corp standing may now find it more beneficial to be taxed at the corporate tax rate instead of their personal tax rate.
However, a counter to this is the fact that S-Corp owners can now deduct 20% of their business income from their personal tax returns. This deduction is currently only set to be in place until 2025, although there is a possibility that Congress extends it. Ultimately, the decision between S-Corp vs C-Corp could come down to your corporate structure and how much money your business earns annually.
How Does S-Corp vs C-Corp Impact LLC Owners?
When entrepreneurs first form their business, they often file as an LLC because they wish to protect themselves from liabilities and debts. They then often believe that because they registered as an LLC, they do not have to worry about making the decision S-Corp vs C-Corp. However, this is not the case.
If a company meets the requirements to elect S-Corp status, business owners could end up saving a substantial amount on Social Security and Medicare taxes. Because owners are treated as employees when opting for S-Corp status, their salaries are deducted as an expense before the business income passes through to their personal tax returns. Even though a business owner registers their company as an LLC, they still have the option to file their taxes as an S-Corp.
The same principle applies for C-Corps. The IRS permits LLC owners to choose to file their taxes under the C-Corp standing without having to make changes to their corporate structure. There are stringent rules for doing so, but it’s a possibility that exists for LLC owners.
When an LLC elects to file their taxes as a C-Corp, they agree to meet corporate income tax requirements for five years. If an LLC wishes to be taxed as a C-Corp, members of the company must agree unanimously. The main reason they would want to do so has to do with the corporate tax rate, which is often considerably lower than the personal tax rate that owners are subject to after business income has passed through to their personal tax returns.
So, just because an entrepreneur registers as an LLC does not mean they should ignore the S-Corp vs C-Corp debate. There are benefits to filing as one versus the other, although it’s important to remember that businesses cannot file as both a S-Corp and a C-Corp. They may only select one when filing their corporate tax returns. However, choosing to do so could save them a significant amount of money on their personal, and potentially their corporate, tax returns.
Business Filing Section