More than half of all U.S. businesses are S corporations, and that share is even higher among small businesses. Why is it so popular? Is it better for all small businesses, or only certain types?
Let’s explore the pros and cons of S corporations and C corporations side by side to determine the best fit for your company.
What is an S corp?
An S corporation elects to be taxed under Subchapter S of the Internal Revenue Code. S corporation is a federal tax status, not a legal business entity.
An S corporation doesn't have to be a corporation. Limited liability companies (LLCs), limited liability partnerships (LLPs), and traditional corporations may elect S corporation status.
S corps are pass-through entities, meaning profits from the business pass through to the owners' personal income to be reported on IRS Form 1040.
This chart shows the breakdown of tax structures for U.S. businesses. The S corporation slice comprises a mix of legal entities including corporations and LLCs.
If you're wondering why LLCs don't have a slice, it’s because the IRS doesn't recognize them. LLCs are taxed by default as sole proprietorships if they have one member or as partnerships if they have multiple members. They can then elect to be taxed as S corps. As a result, you’ll see LLCs in every slice except C corporations.
What is a C corp?
A C corporation or traditional corporation is a legal entity authorized by the state to transact business. It is a separate body from its owners with its own assets, liabilities, obligations, and rights. If you incorporate, your business is automatically a C corp.
C corporations pay corporate income taxes on profits using the IRS 1120 tax form. Any profits that are distributed to owners are taxed again as personal income.
S corp vs. C corp: What’s the difference?
The fundamental difference between S corps and C corps is that an S corporation is a pass-through tax structure and a C corporation is a legal business entity taxed as a corporation.
Let's look closely at the main differences between S corps and C corps to see how they might affect your business taxes and operations.
S corporations were designed for smaller businesses. To qualify, your business must:
- Be owned only by U.S. citizens
- Have no more than 100 shareholders
- Have only one class of stock
These rules can trip up businesses that do not fully understand the implications for ownership and profit distribution.
C corporations can have foreign owners, unlimited shareholders, and multiple classes of stock.
Winner: C corps. S corps are suited for smaller, domestic businesses that want to treat all owners the same way. C corps give companies unlimited growth potential and flexible options for ownership and profit distribution.
Limited liability protections
One major incentive to incorporate your business is to shield yourself from personal liability for the company's debts and legal obligations. S corporations and C corporations both provide limited liability.
Pass-through versus corporate taxation
Income from C corps is taxed at the corporate level. When profits are distributed to owners, they are taxed again as personal income.
S corps benefit from pass-through taxation, which eliminates the double taxation on corporate income and simplifies accounting and tax returns.
Winner: Close tie. Since the C corp tax rate is 21% under the 2017 Tax Cuts and Jobs Act, the corporate tax bite isn't as deep as it used to be, but S corps are still often better for small businesses. Depending on your profit levels and personal income tax brackets, this can go either way.
Qualified business income deduction
As pass-through tax structures, S corporations receive the added benefit of the 20% qualified business income (QBI) deduction, which can substantially lower your S corp tax rate.
Winner: S corp.
Handling of losses
Owners of S corps can declare losses and use them to offset other income. C corporations cannot pass losses through to their owners.
Winner: S corp.
Because S corporations can have only one class of stock, they must distribute profits proportional to shares of ownership. If two partners own 60% and 40%, profits must be split 60/40.
Corporations have a ton of flexibility in distributing profits. Profits can be kept in the company or distributed as dividends. Issuing different classes of stock also makes it easier for C corporations to attract investors and shareholders who don't participate in the business.
Winner: C corp.
In C corporations, fringe benefits are generally deductible at the corporate level and excluded from employee income. Examples include life insurance, healthcare insurance, travel expenses, and adoption assistance.
In an S corp, the cost of these benefits may pass through to employees as compensation and be taxed as personal income.
Winner: C corp.
Complexity and paperwork
Incorporating your business dramatically increases the administrative, legal, and financial paperwork you need to tackle every year. A robust document management system is critical to stay on top of all that documentation.
Winner: S corp, but it depends. Since S corps are pass-through entities, their tax returns are usually simpler than a C corporation's, but their more stringent ownership and profit distribution requirements can up the legal and financial complexity.
How to determine whether an S corp or C corp is right for you
Based on these factors, the score card could tip either way for your small business. A seasoned tax professional can determine which would provide the greater tax advantage for your business. A corporate attorney can advise you on the complexities of ownership and profit distribution.
When an S corp makes sense
S corps are best suited when business owners:
- Want to draw profits as income: If most profits will be distributed, you can bypass double taxation with an S corp.
- Can benefit from losses: If you can use the losses from your business to offset other income, an S corp might be right for you.
- Have a low personal income tax rate: A low personal tax rate, combined with the potential QBI deduction and self-employment tax savings, may mean major tax savings with an S corp.
- Actively participate: If all owners are working in the company in proportion to their ownership, an S corp might be good for your business.
When a C corp makes sense
C corps are better for businesses that:
- Have foreign connections: Unlike S corps, C corps have no limits on foreign ownership.
- Reinvest profits: C corps let you build wealth in your business without drawing it down as personal income.
- Need unlimited growth potential: C corporations can issue unlimited shares of stock.
- Have different types of shareholders: A C corp lets you issue different classes of stock to accommodate a mix of active participants and investors.
- Have owners with high personal tax rates: If your personal income tax rate is higher than C corp tax rates, currently set at 21%, you may do better with a C corp.
- Want to attract investors: Traditional corporations are more attractive to investors.
How to form an S corp or C corp
To form a traditional corporation, you must file articles of incorporation with your state corporations bureau, usually under the secretary of state. Your corporation will automatically be a C corporation.
If you have a business entity such as an LLC or limited liability partnership, you must first file IRS , Entity Classification Election, requesting to be taxed as a corporation. All shareholders in your business must sign both forms to show their consent.
If you're an unincorporated business such as a general partnership, a qualified joint venture, or a sole proprietor working under a "doing business as" (DBA) name, you must form a legal business entity to become an S corporation.
I never thought I'd be writing this about IRS paperwork, but Form 2553 and Form 8832 are deceptively simple. Check a box, sign on the line, and start saving on taxes.
Unfortunately, many a small business owner has fired off a couple of forms and locked into S corp status without realizing all the legal and financial implications. It's truly more complex than the IRS makes it look.
Given the potential financial impact, it makes sense to invest in good legal and financial advice before committing to a structure or filing any IRS paperwork.
And the winner is...
Looks like we have two champions. S corporations and C corporations provide very different, and potentially powerful, tax benefits and ownership capabilities. Finding the best fit for your business takes financial and legal savvy. Investigate all the benefits on both sides and get professional advice on your options.
With some due diligence, you can make sure your business is positioned to reward your efforts and fulfill its potential.