This fact sheet highlights the similarities and major differences between an S-Corporation and a C-Corporation to aid a business in determining which tax classification best meets its needs. Not all businesses goals, future plans, income and situation are exactly the same, therefore any business making this decision should first have their specific situation evaluated by a qualified attorney and accountant.
The general governance and basic structure of an S-Corporation and a C-Corporation are the same. Both are formed according to Minnesota statute and are typically governed by a Board of Directors elected by the shareholders and managed by officers appointed by the Board of Directors. Both entities are also the same in terms of the limited liability shield afforded to shareholders. In both an S-Corporation and a C-Corporation the shareholders are typically not responsible for the liabilities and debts of the corporation. For tax purposes, by default a corporation is a C-Corporation, however, a corporation may elect to be taxed as an S-Corporation by filing form 2553 with the IRS.
A C-Corporation is taxed on its profit at the entity level at the applicable corporate tax rate. There is no pass through taxation. This means that the shareholders will not have the ability to deduct the C-Corporation’s losses on their own individual tax returns. Nor will the C-Corporation shareholders reflect the C-Corporation’s profits on their own individual tax returns. Depending on a shareholder’s tax status, this may or may not be a concern. Only in the event the C-Corporation issues dividends to its shareholders, will the shareholders be taxed on the income received from the dividends. Since dividends are not deductible with C-Corporations, there is “double-taxation” on the same profit at the corporate level and at the shareholder level if and when the income is distributed out as a dividend.
A C-Corporation offers flexibility in that it is not restricted as to the classes of stock it offers shareholders, who can be a shareholder and the amount of shareholders owning stock in the entity. The number of shareholders is unlimited and the C-Corporation can offer preferred stock or other incentives to attract venture capital. If a business wishes to expand and do so by offering equity to many investors, a C-Corporation may be preferable. Because of this, C-Corporations are often the better tax classification if a business foresees that it will rapidly grow by providing equity opportunities for several investors. However, any offering of equity will need to comply with applicable securities’ laws (this is the case with both a C and S Corporation).
In certain situations, a C-Corporation has the ability to offer more tax-free fringe benefits (including health insurance paid on a shareholder’s behalf by the corporation or certain qualified retirement plans) to its shareholder employees and in turn can deduct the cost of providing the fringe benefits to all employees.
Unlike C-Corporations, S-Corporations do not pay income tax at the entity level. All profit and losses are passed through to the individual shareholders, who pay personal income tax on the S-Corporation income. If shareholders are in a higher tax bracket, this could mean that the tax rate paid by the shareholder could potentially be higher than the corporate rate the Corporation would pay at the entity level. However, if the shareholders typically have high income and the S-Corporation is a start-up, deductions from the potential losses of the S-Corporation that pass through to the shareholder may be beneficial to the shareholder.
S-Corporations are limited to only 100 shareholders. In addition, an S-Corporation’s shareholders typically cannot be entities (such as an LLC, a corporation or in certain circumstances, a trust) or a non-resident alien. The stock provided in a S-Corporation has to be all of one class as well. This means that an S-Corporation could not offer preferred stock or some other differing class of stock that potentially could attract venture capital.
In some cases, fewer tax free fringe benefits may be provided to shareholder-employees in an S-Corporation than a C-Corporation. Certain fringe benefits provided to S-Corporation shareholders that own more than 2% of the S-Corporation stock will be taxed as if they were income and such fringe benefits will show up on the shareholder’s W-2 and taxed accordingly.
Additional Assistance and Questions
The information provided within this Fact Sheet is a broad overview and general discussion of only some of the major issues to consider when determining the tax status of your corporation and is not intended to be tax or legal advice. The determination of whether to elect S-Corporation status and whether or not it would benefit your business is largely based on your specific goals and situation. You should seek the advice of competent and qualified counsel to review your specific situation regarding your matter.
NOTE: Any U.S. tax advice contained in this fact sheet is not intended or written to be used, and cannot be used, by the recipient for purposes of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local law tax provisions.
Please contact Brodie Miller at Rinke Noonan at (320) 251-6700 if you have any further questions or concerns regarding the differences between an S-Corporation and a C-Corporation and your specific situation.
© 2012 Rinke Noonan