What’s The Difference Between C and S Corporations?

You’ve started a business and now are deciding on what business entity to classify it as. You’ve come to the right blog. For a general overview of the most common entities, read our earlier blog on them, and then give this one a read if you’re looking to learn more about C and S corporations, their differences, and why it could be a good option for your business.

What’s The Difference Between C and S Corporations?

In short, there are three main differences between C and S Corporations: how they are formed, how they are taxed, and how their ownership is handled. Out of those three differences, taxation is often considered the biggest or deciding factor. C-Corps have a corporate tax rate while S-Corps have what is called pass-through taxation. That means business profits and losses are reported on the owner(s)’ personal income tax returns – we detailed it previously when highlighting partnerships. We’ll dive into the differences and more details of each corporation in this blog.

C Corporations

C Corporation is a legal structure for a business which has the owners – known as shareholders – taxed separately from the business itself. C Corporations are the most common form of corporation, to form one you will need to register with your state. Ownership as a shareholder is based on what level you buy into the corporation at – what class of stock you purchased. Each class or level of stock has different rights. Rights aren’t based on the dollar amount invested but the class of stock purchased. For example, a Class A stock in a corporation has rights to vote and rights to dividends, but Class B stock only has rights to dividends. Higher classes of stock cost more due to the additional rights you as a shareholder receive.

Shareholders are on the business’ payroll as employees, as such social security tax and Medicare tax is withheld up to the statutory limit on their payroll. The business matches the social security and Medicare tax withheld on payroll. A C Corporation pays taxes on the net income of the business; come tax season as a shareholder, you’ll file Form 1120 for the business which is due on April 15^th (or the Tax Day of that year) and pay any tax due on the profits at that time.

As a shareholder on payroll for the business you can’t receive distributions from the business, but you can receive a dividend – as mentioned above with stock rights. But therein lies the biggest issue with C Corporations: double taxation. The business pays their own tax and to earn money out of the company you need to be on the payroll and you will pay income tax on your salary. Another way to receive compensation from the corporation is you can receive a dividend – the issue with the dividend is that it doesn’t lower the net income of the business, so that money is taxed twice. It is taxed once when it is income with the businesses and then a second time when an owner/shareholder receives it as a dividend it is taxed when you file your personal return. Thus, the amount that is taken by an owner as a dividend can be taxed twice in a year.

S Corporations

S Corporations are formed when a C Corporation choses to have its shareholders pay the tax rather than the business itself. Registration is required as a corporation with your state like a C Corporation, but after registration you’ll request permission from the IRS for status as a S Corporation by filing a Form 2553. The reason S Corporations need to request status is due to their taxation structure as a pass-through entity. Taxes for the business are passed through to the owners – shareholders. The company would file a Form 1120S, due on March 15^th. Again, like with a partnership, a K-1 form is provided to the shareholders to report their share of the taxable net income on their personal return. Like C Corporations, shareholders need to be on the payroll to receive funds from the business and must be paid a fair and equitable wage for the work performed. This is something that the IRS does keep a close eye on, by referencing the going rate to ensure that a fair wage is being paid to the shareholders. In S Corporations, all shareholders have the same class of stock – no matter how much they bought in for.

In S Corporations an owner or shareholder can take funds out of the business – this would include recouping any original funds you invested into the business – is by being on the payroll. If you are not taking funds out, then you are not required to be on the payroll. Shareholders don’t pay a shareholder employee tax, but the company still matches social security and Medicare taxes that are withheld. Shareholders can also receive distributions in addition to their wage. Any losses of the business will decrease personal income if a shareholder has basis. Basis for S Corporations is slightly different then with Sole Proprietors and Partnerships. In S Corporations, any loans guaranteed by you as a shareholder don’t create basis. However, all other components of creating basis remain.

The key point here is that for an S-Corp if you are going to take funds out of the company, you must be on payroll first. If not, you run the risk of any loan repayments or distributions being called hidden payroll by the IRS in an audit and must pay back payroll taxes and massive penalties for not filing payroll or paying in the taxes when due. Thus, why you must first have salary that meets the fair and equitable level and then you can take distributions.

The Temptation of S-Corporations

While it may be tempting by reading the descriptions to want your business to be a S Corporation to avoid having money taxed twice, you need to remember that key point of paying shareholders in S Corporations. They must be on payroll and be paid a fair and equitable rate for they work they do. The IRS tracks this information and compares your in-house rates to the going rate in the industry for that job or role. It’s best look at all aspects of your business to decide if a S Corporation would be the best choice for you.