Business ownership brings many exciting milestones, and one of the biggest is incorporation. There are many ways to incorporate, C corporation and S corporation being two of them. You could also become a B corp — a company that seeks to serve the broader community — or a limited liability company (LLC).
Entrepreneurs often choose C corps or S corps over other options in order to bring on outside investors. S and C corporations tend to be more welcoming to investors. But which do you choose? Read on to learn the difference between a C corp and an S corp, and what each structure can do for your business.
What is a C corp?
A C corporation is a for-profit organization and a distinct legal entity. When a business establishes itself as a C corporation, the company's assets and liabilities become separate from the owner's. If you incorporate your business as a C corporation and a customer files a lawsuit against the company, the court can't pursue your personal assets to pay damages. The same is true if the company goes into debt. In that case, your personal assets as the owner would be safe.
C corporations can hold assets and must pay taxes on their income. The company's shareholders are responsible for managing owned assets, but the corporation itself maintains legal ownership. If your company makes $1 million after taxes and expenses in its first year, that $1 million belongs to the company.
What is an S corp?
An S corp is also a distinct legal entity, but there are different rules for taxation and asset distribution. S corps don't pay corporate taxes. Instead, income "flows through" to shareholders who pay taxes on that income on their personal returns.
Also, an S corp can have no more than 100 individual shareholders, each of whom must be a U.S. citizen or resident. It may not have institutional or non-U.S. shareholders. Otherwise, the structure and function of an S corporation is similar to a C corporation.
Advantages and disadvantages
When you’re figuring out how to start a business and structure your business, choosing between a C corp and an S corp structure can be challenging. Consider these factors before making your decision.
C corps are more flexible than S corps and often leave more room for growth, but they are also costlier.
- Preferred corporate tax rate: The Tax Cuts and Jobs Act reduced the corporate tax rate to 21% from 35%. C corp tax rates pay at this reduced level.
- More shareholder allowances: Any individual or entity can own shares in a C corp, and there are no limits on how many shareholders the company can have. This allows a C corp to go public by offering its stock on the open market.
- More financing options: Due to the lack of restrictions on the number and type of shareholders, C corps can obtain capital from more varied sources, including investment firms.
- Double-taxed income: Because a C corp pays taxes at the corporate level and shareholders pay taxes on their allocation of profits, C corp revenue goes through two rounds of taxation.
- Costlier to form: According to the U.S. Small Business Administration, the cost of establishing a C corp is higher than the cost to incorporate another way.
- More paperwork: C corps require more extensive record-keeping and forms than other business structures.
An S corp setup imposes more regulations on investors and stock types but offers certain financial advantages.
- No double taxation: Because S corp taxes aren't paid at the company level, payouts to shareholders are only subject to individual income tax. The company doesn't pay tax as an entity.
- Loss offsets: Just like profits count as part of a shareholder's income, losses count as personal losses for tax purposes. Shareholders can use those losses to reduce their taxable income.
- Business income deductions: The 2017 Tax Cuts and Jobs Act allows eligible taxpayers, including qualifying S corporation owners, to deduct up to 20% of the net profit they collect from their business's income.
- Investor restrictions: Only individuals who are U.S. citizens or residents can be S corp shareholders. This excludes partnerships and investing firms.
- Potentially higher taxes: Because there's no corporate tax, the S corp tax rate is equal to the personal income tax rate.
- No public offerings: Because an S corp can have no more than 100 shareholders, it's ineligible for the public stock exchange.
- Only one stock class: The U.S. government prohibits S corporations from having more than one type of stock. This can make it more difficult for companies to attract investors, who often want priority stock structures.
S corp vs. C corp: key differences
S corps and C corps have much in common, but the differences can affect all aspects of how you do business. Here are the most important ones.
To become a corporation of any kind, including an S corp or C corp, a business's owners must file articles of incorporation with the state where the business will operate. The articles of incorporation include the basic information about your company, such as its name, type of business and number and value of shares offered.
Depending on your state's requirements, you may also have to file bylaws, which detail how your corporation governs itself.
By default, corporate filings create a C corporation. If you're interested in setting up an S corp, file S corp tax form 2553 with the Internal Revenue Service. This tells the IRS that company profits will go directly to shareholders, and that the company will not pay corporate tax.
The owners of a corporation have financial interests in the company and contribute to business decisions. In both S corps and C corps, shareholders serve that role. Each shareholder's interest determines their level of influence. If a single shareholder owns more than 50% of the available stock in a C corp or S corp, they have a controlling interest. They have more votes and influence on company decisions.
S corps are restricted to no more than 100 shareholders who must be a resident or citizen of the U.S. This means that an S corp will have more limited corporate ownership than a C corp, which can have unlimited shareholders and go public on the stock exchange.
C corporations pay taxes at the company level by filing quarterly corporate tax returns (Form 1120). The company then passes profits to shareholders as dividends, taxable as personal income tax.
S corporations don't pay corporate tax returns. The only taxes due on an S corp's income are the shareholders' personal income taxes. The structure of an S corp also allows shareholders to write off losses on personal returns if they lost their personal funds.
Shareholders are partial owners of a company. Each shareholder receives a portion of profits based on their portion of ownership. Shareholders are also responsible for electing the company's board of directors.
For S corporations, the government limits the number of shareholders and only allows individuals to invest. An S corporation can have up to 100 individual shareholders, each of whom must be a legal U.S. resident or citizen.
C corporations can have any number of institutional or individual shareholders.
Class of stock
A stock class is a type of share in a company, differentiated by the benefits it offers shareholders. For example, many companies have preferred and common stock options. Preferred stockholders have priority claims over common stockholders regarding assets and dividend payments.
Because an S corporation can offer only one type of stock, no shareholder can have a priority interest. Investors must have the same type of stock as employees and anyone else with a share in the company.
C corporations can have as many stock types as their owners choose to offer. They may divide their stocks into preferred and common or offer multiple classes, each with its own benefits.
Profits and losses
S corporations must pass all revenue to their shareholders, while C corporations don't have that responsibility. The law doesn't allow an S corporation to retain any earnings. Individual shareholders may leave their S corp distributions in the corporation, effectively reinvesting that money, but must still pay taxes on it.
A C corporation pays taxes on profits and may then distribute the remaining profits as dividends. Unlike an S corp, the C corp isn't legally obligated to distribute all profits. It distributes dividends as an incentive to investors.
S corps and C corps both recognize losses at the corporate level, not at the shareholder level. For example, if you own shares in a C corp and the company loses $500,000, you don't personally lose that money.
However, as mentioned previously, owners of an S corp may be able to write off those losses on their tax returns. C corp owners are ineligible to write off corporate losses. Because C corps don't have to pass profits or losses to shareholders, the corporation is fully responsible for those funds.
When you should consider forming a C corp
Each type of business structure suits different goals and ownership types. C corps give some business owners pause because of the double taxation rule, but the benefits are often worth the drawbacks.
A C corp might be the right choice for your business if:
You want to go public. "Going public" means offering your company's stock on a public exchange. There are many reasons to go public, including:
- Allowing early investors to cash out their investments
- Expanding access to capital
- Raising money to fund major projects
- Attracting publicity and recognition
C corps give you the option to go public, but you don't have to do so until you're ready. The process takes time and money, so most businesses wait until they have the necessary resources.
You want to pursue institutional investors. An institutional investor is an entity that collects funds from smaller investors — individuals or organizations — to make a larger investment.
Unlike S corporations, C corps can distribute stocks to organizations as well as individuals. This lets them pursue institutional investment groups with company shares as incentives.
When you should consider forming an S corp
For some businesses, the flexibility of being a C corp isn't worth the tax disadvantages and higher level of complexity. You might choose to set up an S corp if:
Your revenue is still moderate. Double taxation can slow your growth as a new business. If you form an S corp, you won't have to pay taxes at the corporate level. You can use this "extra" money to buy equipment, market your business or otherwise fund early-stage growth.
You plan on having fewer than 100 individual shareholders. If you have a limited number of intended shareholders and don't plan to go above 100 or go public, the restrictions on an S corp are unlikely to limit you significantly.
Your shareholders will receive distributed profits. A company that already plans to distribute all revenue to shareholders, rather than only issuing dividends, can be a good fit for an S corp.
You might want to change later. It's possible to transition from an S corp to a C corp and vice versa. However, to become an S corp, a C corp needs to meet all S corp requirements, including the number and type of investors. C corps have fewer limitations. If you become an S corp first, you can transition to C corp status if you want to grow your investor base.
The bottom line
Establishing a business involves a lot of decision-making. Even the most exciting parts, such as choosing what to call your business, come with administrative challenges like how to trademark a name.
Choosing a C corp versus an S corp can feel like one of the biggest and heaviest decisions facing a business owner — often even bigger than which of the best small business loans to apply for. Consider your shareholders' needs and your short- and long-term business goals, including whether you need the tax benefits of an S corp or the flexibility of a C corp.
Remember, you can transition from an S corp to a C corp or vice versa, so don't impose too much stress on yourself. Think of it more like finding the best business checking accounts — important, but not irreversible. Determine what will get you to the next step, and start moving forward.