Incorporation is often chosen when a business is founded and forgotten about once operations begin. However, you can change from a C Corporation to an S Corporation, and there are a lot of crucial benefits.
S Corporations vs. C Corporations
What is an S Corporation?
An S Corp acts as a pass-through entity. You’ll file taxes using Form 1120S, but the business won’t pay income tax. Instead, the income or losses are passed to the shareholders, who will report the earnings or losses on their own personal income tax.
While electing to be an S Corp is part of many tax planning strategies, this entity has advantages and disadvantages.
What are the Tax Advantages of an S Corporation?
The main benefits of an S Corporation are:
- Single taxation: Only the business shareholders are taxed. While the maximum personal income tax level is 37%, it’s still cheaper than double taxation.
- Deductions: Under current law, an S Corp can deduct up to 20% of qualified business income from their taxes, further reducing the tax burden of shareholders.
- Losses: If a business experiences losses, the loss is passed down to the shareholders, who can then offset their tax burden by claiming the losses.
While there are a lot of tax-related advantages of an S Corporation, there are disadvantages that must also be considered.
What are the Tax Disadvantages of an S Corporation?
From a tax perspective, it may be advantageous to elect as an S Corp. Still, some disadvantages must be considered:
- Shareholder Limits: An S Corporation is capped at 100 shareholders, so there is a limit to the number of equity investors that you can take on. If you need to raise money or issue more shares, a C Corp is the best option.
- Shareholder restrictions: As an S Corporation, your shareholders must be individuals who are U.S. citizens or reside in the country legally. These restrictions make it more difficult to raise outside funding for the business.
- Classes: Stocks for these entities must all be the same. You cannot create stocks with distributions or other preferences.
- Transfer restrictions: Due to shareholder restrictions, an S Corp will have transfer restrictions on their stock. These restrictions are in place to ensure that there are no issues with the IRS.
Strict shareholder restrictions are the main disadvantage of an S Corp. If you ever plan for an IPO or want to exit the corporation, a C Corporation is often better.
It’s also important to note that you can be an LLC and elect to be treated as an S Corporation for taxes purposes. This is also a common tax planning strategy, but one we will save for another blog.
What is a C Corporation?
According to the IRS, a C Corporation is the default corporation. From a legal standpoint, a C Corp is a separate, taxable entity. Due to this designation, there are advantages and disadvantages of forming a C Corp.
What are the Tax Advantages of a C Corporation?
If you form as a C Corp, the main advantages are:
- Shareholders: Your business can have an unlimited number of shareholders as a C Corp. If you need to secure investors, give out shares to employees or want the company to go public, a C Corp may be beneficial.
- Ownership: Shares in the company can be owned by anyone, including non-US citizens and other businesses.
- Capital: It’s easier to secure equity financing compared to an S Corp because the restrictions on ownership are much lower.
- Classes: Stock classes for a C Corp have no restrictions, and it’s possible to have stocks with distributions or dividends, too.
- Tax rate: Corporate tax rates change with tax bills, but the current rate is 21% – lower than the maximum personal income tax. However, there are rumors of this rate increasing to 25% or 28%, which is still lower than the 37% maximum personal tax rate.
Another often overlooked advantage of a C Corp is that benefits can be deducted. If you offer your employees disability, health, or life insurance, these expenses are deductible as long as the benefits are offered to 70% of employees.
S Corporations cannot deduct these expenses, and any shareholder with at least a 2% stake in the business will pay taxes on these benefits.
While there are some significant advantages of the C Corps, there are also disadvantages that must be considered.
What are the Tax Disadvantages of a C Corporation?
C Corporations are ideal when you want to issue preferred stock, make distributions to shareholders, or plan an IPO. However, they have the disadvantage of double taxation.
The key disadvantage of a C Corp is double taxation wherein:
- The corporation is taxed at the current 21% rate
- Shareholders are taxed on their dividends
If you’re operating a smaller business that has fewer than 100 shareholders, it may make sense to elect to be an S Corp.
Choosing Between an S Corp and C Corp
For a small business that can fit within the S Corp requirements, it’s often a good idea to consider electing as an S Corp. However, there is no one-size-fits-all answer as to whether an S Corp election is the right choice for your business.
If you plan to do any of the following, a C Corporation may be best:
- Secure capital
- Sell stocks globally
- Attract foreign investors
- Issue multiple stock classes
Small businesses that elect as an S Corp often find that there are tax savings. However, if you want the most flexibility when raising capital, a C Corp is a good choice.
Due to there being so many variables involved when electing for either type of entity, it’s best to work with a professional on a one-on-one basis.
A CPA or tax planning professional can help you better understand which entity is best for you. While we covered many of the key differences between S and C corporations, there’s still a lot left to discuss.
We advise that you sit down, review the key differences for yourself and determine which entity is best for your type of business.
Need help determining which corporation is right for you? Schedule a call today.