C Corporations, or “C Corps” as they’re commonly known, are the primary format of publicly held companies. Their shares can be easily bought and sold on public stock exchanges since there is no limit on the number of shareholders they can have. In addition, unlike S Corporations, C Corp shareholders are not limited to natural persons (can be corporations or partnerships), nor is there a requirement that they be US residents or citizens.
C Corp status enables a business to function as a separate legal entity, able to enter into contracts, borrow money, hire employees and perform all other business functions without personal guarantees from its shareholders. This separation enables shareholders to participate in the company’s profits, but without the potential liability that a sole proprietor or partner would have in the event of liabilities, lawsuits and income tax obligations.
S Corporations, or “S Corps”, are similar to C Corps in that they are owned by shareholders, and provide all the same legal protections from debts, lawsuits and other company liabilities. They can also conduct business as a separate legal entity from their shareholders, including the hiring of employees.
In order to become an S Corp, the business must file IRS Form 2553 (Election by a Small Business Corporation) with the Internal Revenue Service, and meet the following requirements:
- The business must first be either a C Corp or a Limited Liability Company (LLC) (which have the option to elect to be taxed as a corporation)
- The maximum number of shareholders is 100
- Shareholders must be natural persons, not partnerships or other corporations
- The business must be a domestic corporation, and its shareholders must be either residents or citizens of the US
- An S Corp must have only one class of stock (where a C Corp can have both common and preferred stock, and various classes of each)
Tax Treatment of Each Corporation Type
A C Corp is a separate entity for income tax purposes. It files a corporation income tax return (IRS Form 1120), where it reports its profit or loss, and pays income taxes at the corporate income tax rate based on its profits.
Distributions of profits to shareholders in the form of dividends holds the potential for double taxation. Since dividends are paid out of the corporation’s after-tax income, they are then subject to the individual income tax rates of each individual shareholder to whom their paid. Thus the same income is taxed twice.
C Corps can get around this by paying their shareholders in salary, benefits and bonuses, which while taxable to the shareholders, are tax deductible to the corporation. However, for corporations with many shareholders, most of whom are not also employees of the company, this attempt to avoid double taxation will not be possible.
S Corps eliminate the double taxation issue that is faced by C Corps. They do that by distributing profits to their shareholders, in the same way that partnerships do. The income is then taxed only at the individual shareholders rate, with no tax liability to the company itself.
This form of income tax consideration is also a benefit when the company incurs losses. The losses can be passed on to shareholders, who can use them to offset other income they have. By contrast, losses to C Corps can only be carried forward to lower future income tax liability.
Profits and losses in an S Corp are allocated to each shareholder based on his or her interest in the business. The percentage interest in the business is determined by each shareholders initial capital contribution to the company, plus any subsequent contributions, less any distributions made, divided by the total amount of capital in the company from all shareholders.
Allocations are reported to each shareholder via IRS Schedule K-1, in much the same way it’s reported for partnerships.
Comparison Between the C Corporation and S Corporation
|Created under||State law||Corporation status is created under state law, but S Corp status is achieved by filing IRS Form 2553 (Election by a Small Business Corporation)|
|Purpose||To create a distinct legal entity for the purpose of income taxes, liabilities and legal challenges||Same, but with additional income tax option (See below)|
|Tax treatment||Corporation files income tax returns (IRS Form 1120) based on its own profits; unless dividends are paid shareholders can avoid double taxation by being compensated through salary, benefits and bonuses, which while taxable to the shareholder, are also tax deductible to the corporation||Under S Corp status, business files annual income tax returns (IRS Form 1120S); all net income of the S Corp are passed through to its shareholders on a pro-rata basis, where it will be subject to each individuals own personal income tax rate; there is no double taxation since the S Corp itself pays no income tax|
|Corporate formalities (filing requirements and recordkeeping)||In order to determine and maintain separate legal status of the corporation, the company must issue stock, maintain adequate capital in the company, keep asset accounts separate from those of shareholders, appoint officers, hold annual meetings, and record minutes of those meetings – shareholder liability protection can be lost if these procedures are not maintained||Same|
|Number of shareholders permitted||Unlimited||No more than 100|
|Shareholder restrictions||Can be natural persons or legal entities (corporations and partnerships), can be foreign or domestic||Must be natural persons (no corporations or partnerships), and must be US residents or citizens|
|Liability protection||Shareholders are generally not responsible for debts and other obligations of the corporation, including taxes and legal claims (See Corporate formalities above for exceptions)||Same|
|Management||Shareholders can manage the business operations of the corporation, or they can hire non-owners||Same|
|Life of business entity||Since a corporation is a separate legal entity, it can continue in existence forever; the death of one or more officers of the company will not necessarily result in it’s termination||Same|
|Status works best for||Large businesses with many shareholders (more than 100), companies with foreign owners or ownership by other business entities, or companies looking to become public companies||Small, closely held companies with relatively few (less than 100) shareholders, all of whom are domestic natural persons|