Whether you're just starting out or considering incorporating an existing business, your choice of entity is critical. I’m personally partial to limited liability companies for most small businesses, but many individuals still want to conduct business as a traditional corporation.
Several forms of corporations exist, but the two most common for-profit types are S-corporations and C-corporations. If you’re planning to incorporate, you need to understand the difference between them and how they can affect you, especially your bottom line.
Creating a corporation
To create a corporation, you begin by filing articles of incorporation with the Department of State. Keep in mind that your articles of incorporation do not state what type of corporation you are filing. By default, newly formed corporations are considered C-corporations under subchapter “C" of the tax code. S status requires your entity to file for it with the Internal Revenue Service (IRS).
On many levels, the choice between C or S status is irrelevant. This is because both forms provide owners with limited liability. Limited liability is usually the primary reason individuals decide to incorporate in the first place. It shields you from personal liability resulting from the ordinary, everyday operation of your company. This shield comes from the fact that corporations are considered separate entities from their owners and directors. Corporations, nonetheless, are still owned by their shareholders and controlled by their boards of directors.
The difference between S and C corporations
The real difference between C-corporations and S-corporations comes down to tax treatment. Traditional C-corporations face two levels of taxation. Not only does the entity pay taxes on the net income it generates, but its shareholders pay a secondary layer of taxes on the distributions they receive from the entity. S-corporations are not subject to this double layer of taxation. They are instead subject only to a single level of taxation at the shareholder level, and are referred to as “pass-through" entities. In this sense, corporations which choose an S election are treated more like LLCs or partnerships.
To be an S-corporation, your entity must have no more than 100 shareholders, all of whom must be U.S. citizens or resident aliens. Shareholder status is not limited to natural persons, but can also be enjoyed by other corporations. Remember, corporations are separate entities in the eyes of the law.
In order to choose S status from the beginning, the corporation must file an S election with the IRS within 75 days of formation. If you elect S status from the beginning (or during the election period), your business will never be treated as a C-corporation. But even if you miss that window and are considered a C corporation for tax purposes, all hope is not lost. C-corporations can convert to S status, but it is not a simple process.
Complicated accounting rules mean that many C-corporations find it difficult to convert to S status. There is a significant risk of still facing double taxation due to a built-in gain tax that was instituted to take effect upon converting from C to S. Nonetheless, converting from a C corporation to an S corporation is an available option.
When one weighs the costs and benefits associated with a C-corp versus an S-corp, it doesn't make much sense for most small business owners to stick with C-corp status. Most small businesses can’t afford the hit of paying the two levels of taxation that accompany C-corp status. Also, conducting business as an S-corp allows business owners to personally claim losses on their taxes – a feature simply not offered by C-corporations.
At the end of the day, corporations have their time and place. If you’re considering one over an LLC, you need to at least make sure you elect wisely when forming one so as to get the most out of your chosen entity. Last but not least, rules and laws change regularly, so always consult with counsel when choosing an entity form. This article gives one a sense of the differences between S-corps and C-corps, but there are still other issues that could affect your choice of entity.