S-Corp Versus C-Corp: What is the Difference?
In the financial world, an S-corporation and a C-corporation are two different entities. An S-corporation is a corporation that elects to pass corporate income, losses, deductions, and credit through to its shareholders for federal tax purposes.
The corporation itself does not pay taxes; instead, the shareholders report the flow-through items on their tax returns. A C-corporation is a corporation that is taxed separately from its owners.
Here is an overview of the points covered in the article:
- What is a corporation?
- What is a C corporation?
- What is an S corporation?
- S Corp vs. C Corp
- Pros of S Corporations
- Cons of S Corporations
- Pros of C Corporations
- Cons of C Corporations
What is a Corporation?
A corporation is a legal entity that can enter into contracts, sue and be sued, and pay taxes. In the United States, corporations are chartered by the state where they do business. They may be nonprofit or for-profit companies.
For federal income tax purposes, corporations are taxed separately from their owners. Corporations generally enjoy many tax advantages over partnerships and sole proprietorships because of this separation; however, as a result of this "separate taxation," corporate profits are subject to double taxation since corporate income may be taxed at the corporate level and again when it is distributed to shareholders.
The corporation's articles of incorporation must include a statement that the corporation will not be organized or operated for profit. If the corporation is organized for profit or works for profit, it will be taxed on its earnings as any other business would. State laws vary between an S corp and c corp in finance.
What is a C corporation?
The C-Corporation is the most common business structure for a new business. When you form a C Corporation, you create a separate legal entity afforded its tax identification number (EIN).
Treatment as a Separate Entity: The first thing to understand is that the corporation and its shareholders are treated as two separate entities for most purposes. This means that the corporation itself is subject to income tax, but the shareholders are not. It also means that the corporation has its own set of books, its officers and directors, etc. All of these things make it easier to run the business. It's also important to note that while corporations can sell stock to raise capital, they cannot sell stock to their owners (shareholders).
Taxation of Profits: A C-Corporation may be subject to double taxation. The first time income tax is paid on corporate profits is distributed as dividends to shareholders. Shareholders then pay income tax on those dividends in the year they receive them. The second time corporate gains are taxed is at the corporate level when they are distributed as salaries or bonuses to corporate officers or employees.
C-Corporations are characterized by having a separate legal existence from their owners. C-Corporations are taxed separately from their owners and pay income taxes. The corporation itself is responsible for paying the taxes, not the shareholders.
What is an S-Corporation?
An S-Corporation is a corporation that elects to be treated as a "pass-through" entity for tax purposes. In other words, the income and expenses of an S-Corporation are passed through to its shareholders to determine their income tax liability. This means that any profits or losses that the S corporation generates will not be taxed at the corporate level; instead, they will be reported on the shareholders' tax returns on their respective shares of stock. The same holds for income tax deductions.
Several companies choose to incorporate as S corporations due to this benefit, especially if multiple shareholders own the company and each has to pay corporate tax rates on any profits generated by the company.
An S-Corporation is not subject to federal income tax; instead, it "passes through" its earnings and losses to its shareholders for them to report on their returns. This saves the corporation money because corporate taxes are higher than individual rates. The savings can be distributed to shareholders as dividends, which are not taxed at the corporate level (They are still taxed at the shareholder level.)
Shareholders of an S-Corporation are also protected from personal liability for business debts and actions, except in fraud cases. This differs from a regular corporation, where some steps can leave shareholders with personal liability for corporate debts and actions.
S-Corp Versus C-Corp
The same rules apply to both corporations regarding what they can and cannot do. But the IRS does give some preferential tax treatment to the s corporation that makes it worth considering for some small businesses.
A big difference is that s corporations don't pay taxes in terms of taxation. Instead, they pass income and losses through to their shareholders. This means you only pay tax on your payment if you take money out as distributions. The corporation itself doesn't have to pay taxes on profits or losses. This can be helpful when there aren't enough funds left after paying employees and other expenses to pay itself a profit. In this case, the corporation isn't taxed. It just directly passes its losses through to shareholders. The loss is deducted from their income when filing their tax returns.
Corporate owners also have more flexibility to deduct health insurance premiums from their taxable income. S corporations can deduct up to 25 percent of their premium costs for themselves, their spouses, and dependents. Corporate owners aren't allowed to deduct any premium expenses for themselves before calculating how much of a profit they've made for the year.
In contrast, the owners' assets are protected from lawsuits and creditors with an S-Corporation. Profits and losses are passed through to individual tax returns, which means that the company does not pay corporate tax on profits.
Pros of S-Corporations
S-Corporations can offer certain tax advantages over C-Corporations, particularly for small businesses. However, it would be best if you weighed the benefits against the limitations of S corporations before deciding to incorporate your business as one.
The IRS considers many types of small businesses "S-Corporations," including those qualified under Subchapter S of the Internal Revenue Code. This classification is available for companies with 100 or fewer shareholders; have only one class of stock; and have no more than 75 percent of their income derived from passive investments, such as rental properties, stocks, and bonds. These requirements allow many small businesses to qualify as S corporations.
One benefit to an S-Corporation is that any shareholder can be held personally liable for corporate debts and liabilities. Still, they don't have to report the income on their tax returns. Instead, the corporation files a separate tax return on Form 1120S, which passes all profits and losses to each shareholder's tax return. If there are no profits, there will be no taxes due personally.
S corporations do not pay federal taxes themselves; instead, their profits or losses flow through to the individual shareholders for taxation at their income tax rates.
Cons of S-Corporations
There are certain drawbacks regarding the administration of an S corporation versus a C corporation. For example, an S corporation requires more record-keeping and must file a tax return.
The S corporation's shareholders are responsible for reporting the business's income and paying taxes on their share of profits.
An S corporation is not required to pay employment taxes on wages paid to its employees. Still, it does have to pay employment taxes on distributions from the corporation to its shareholders.
S corporations can also be subject to double taxation. Since an S corporation passes corporate losses through to its shareholders, those shareholders have to pay taxes on those profits even if they have not withdrawn the money from the company. This can be especially harmful if the company has high losses in later years.
Pros of C-Corporations
The main benefit of a C corporation is that it provides the owners with both personal and corporate tax shields. The corporate shields the owners from personal liability, and the personal shields them from corporate taxes.
The income of a C corporation is taxed twice, once at the corporate level and once at the shareholder level. Shareholders in a C corporation are taxed on the dividends they receive, which results in double taxation. However, they may be eligible for certain tax deductions related to these dividends.
C corporations offer flexibility in terms of finance and operations. For example, they can have limited or unlimited life spans and carry out any lawful activity under their articles of incorporation. They are also not bound by any limitations on ownership or foreign investors.
Cons of C-Corporations
Owning a corporation is like wearing a tuxedo: You look good, you feel confident, and you're in the upper echelon of business. But there are downsides to owning C corporations, most notably the 12-figure price tag.
In addition to paying for incorporation fees and legal fees, a C corporation must pay corporate income taxes on its profits -- which means that a corporation's profits are taxed twice (as corporate income taxes and then as individual income taxes when those profits are paid out as dividends). Here's the thing: A C corporation is generally taxed twice -- first at the corporate level and then at the shareholder level. It's double taxation, which is why S corporations aren't allowed.
Wrapping Up
The rules for determining whether a business is organized as an S corporation or a C corporation depend on the type of business entity. There are more pros and cons to each type of corporation, as you can see. Understand the essential features of a C Corporation, S Corp to help determine which one best fits your small business needs.
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Key Takeaways
If you're considering creating a corporation, you may be asking yourself whether you should form an S corporation or a C corporation. Your answer will depend mainly on the type of business you're running and how many shareholders you have. If you're planning to grow your company, C corporations are typically your best bet for many reasons.
The big difference between an S corporation and a C corporation is that the income and losses of an S corporation "pass-through" to each shareholder's tax return. A C corporation has to pay corporate tax on its profits, making it more expensive since the profits have to be distributed to shareholders as dividends.
S-Corporation and C-Corporation are two different types of corporations. In an S corporation, the business is considered a pass-through entity. The tax income or losses are passed through to its shareholders and included on their tax returns. In a C corporation, taxes are paid directly by the corporation on its income.