When launching a new business, it is a good practice to set up a separate legal entity for the company, such as a limited liability company or corporation. Creating an entity generally allows you to protect your personal assets from business creditors, creates a formal legal structure for operating your business, provides tax benefits and typically makes your business more attractive to lenders and investors. The best structure for your business depends on the intended strategy of your new business venture, if you intend to raise capital from investors, and in many cases your tax strategy. With respect to your tax strategy, two common options are an S-Corporation (S-Corp) and a C-Corporation (C-Corp).
HOW ARE S-CORPS AND C-CORPS SIMILAR?
S-Corps and C-Corps are very similar. “C-Corp” is simply another term for a regular corporation, while “S-Corp” refers to an entity that is incorporated under Sub-Chapter S of the Internal Revenue Code for a specific tax status. Both require setting up a separate legal entity, which has the authority to enter into contracts, own assets and hire employees. Shareholders also have limited liability protection, meaning a creditor cannot seize their personal assets. A common misconception is that you an S-Corp is an entity type that you choose when you create your entity. Instead, it is an election made with the IRS governing how the business is to be treated for tax purposes.
To establish either type of corporation, owners must file Articles (or Certificate) of Incorporation with a state’s Department of State. Certain states, like Delaware, also require every corporation to have bylaws. Even if bylaws are not mandatory in your state of incorporation, it is generally a good idea to have a set of rules that govern the internal affairs and day-to-day operations of your company to avoid disputes in the future. It is equally recommended to adopt corporate resolutions, i.e., Directors’ Initial Resolutions and Shareholders’ Initial Resolutions, to approve all the initial actions taken by the incorporator, shareholders and/or directors.
Moreover, both types of corporations operate with a board of directors and have shareholders. Day-to-day management is handled by a CEO (or president) and executives. Pursuant to their bylaws, they must observe certain corporate formalities, such as having shareholders and board meetings, maintaining corporate records, preparing annual reports and other obligations.
WHAT ARE THE DIFFERENCES BETWEEN S-CORPS AND C-CORPS?
There are some significant differences between the two types of corporations. The primary ones relate to taxation, shareholder restrictions and the availability of multiple classes of stock.
Entities with S-Corp status are subject to the following rules:
- Domestic entity only. An S-corp must be a U.S. domestic entity.
- Pass-through taxation. S-corps elect to have their profits “flow-through” the corporate entity directly to the shareholders. As a result, the earnings of an S-Corp are only taxed once they reach the shareholders as profit, avoiding what is commonly referred to as “double taxation” of C-Corps. Shareholders can deduct up to 20 percent of their business income as well as write off their business’s losses on their personal tax returns.
- Shareholder restrictions. An S-Corp cannot have shareholders that are corporations, limited liability companies (LLCs), partnerships or non-resident aliens. Shareholders must be U.S. citizens, permanent residents or those individuals who meet the “Substantial Presence Test” for residency. Certain trusts, estates, and tax-exempt non-profit organizations may also qualify as shareholders. Further, there is a cap on the number of shareholders—only a maximum of 100 shareholders is permitted for an S-corp.
- One class of stock. S-Corps may only issue one class of stock, meaning that all outstanding shares must carry identical rights and privileges. No preferred stock may be issued.
C-Corporations differ as follows:
- Default at formation. A C-Corp is the default form of entity when filing for incorporation. In order to become an S-Corp, owners must file a federal election with the IRS to alter how they are taxed. In addition, they may need to file an S-Corporation election with the Department of State of their respective State.
- Double taxation. C-Corps are “double-taxed” meaning the corporation, as an entity, is taxed on its earnings and those same earnings are taxed once shareholders receive that profit as a dividend. Owners cannot write off corporate losses on their personal income tax returns.
- No owner restrictions. Unlike S-Corps, there are no restrictions on the number or type of shareholders.
- Multiple classes of stock. Different classes of stock with preferential distribution of dividends and special voting rights are permitted.
WHICH CORPORATE ENTITY SHOULD YOU CHOOSE?
The best entity depends on your priorities and goals for the business. C-Corps are easier to form as the default option. They also offer flexibility in ownership in that there are no shareholder restrictions and the company can issue different classes of stock. This can be helpful in allowing companies to give employees stock option incentives or attract various types of investors. It also makes it easier to be acquired by another company or go public in the future.
However, if you are intending to remain a small company, these benefits may not outweigh the tax ramifications. One big disadvantage of C-Corps is double taxation. However, to counter this, the company can deduct 100 percent of their charitable contributions on their corporate return up to 10 percent of the company’s income. In addition, C-Corps can deduct certain benefits from employees’ pay, such as health insurance, which may help them attract and retain employees.
S-Corps offer many tax benefits, but they also tend to be more heavily scrutinized by taxing authorities. Owners must take care to comply with all the rules for S-Corps in order to maintain their preferred tax status.
Additionally, the limitations on shareholders and classes of securities can make it more difficult for S-Corps to get investors and expand their business, especially outside the U.S. For business owners who are considering creating an additional class of stock going forward, S-corp might not be the optimal option. However, on the flip side, it can also make it easier to manage the company and seek input from the owners. S-Corporations tend to be a better fit for those who want owners to contribute to the company and are looking to remain smaller in size.
Choosing the type of entity for your business is an important decision which should account for both short-term and long-term goals. Before you move forward, consult an experienced attorney to discuss the pros and cons of the options and picking which option may be best for you.
