All small business owners must choose a business structure. Whether you are starting a new business or have an existing business structured as a limited liability company (LLC) or sole proprietorship, there are advantages and disadvantages that come with each type of legal entity.
Read on below to learn the pros and cons of small businesses becoming an S corp or a C corp. While these are good considerations to keep in mind, you should also speak with your accountant or attorney. They can help you determine which business structure would be best based on your business income, eligibility requirements, and other factors.
What Are S Corporations and C Corporations?
In the United States, the Internal Revenue Service taxes a small business corporation as either a C corporation (C corp) or an S corporation (S corp). An S corp is treated as a pass-through entity for federal tax purposes, which could lead to certain tax benefits. An LLC can also elect to be taxed as an S corp.
The difference between an S and a C corp involves the way they pay taxes under the Internal Revenue Code. A C corp files its own income tax return and pays taxes on its income at the federal corporate income tax rate. Every corporation in the United States is, by default, taxed as a C corp unless it has elected to be taxed as an S corp instead.
A single-member LLC is by default taxed as a sole proprietor. And a multi-member LLC is taxed as a partnership unless it elects to be taxed as an S corp. (Both single and multi-member LLC owners can make that election.)
An S corp’s owners, who are referred to as shareholders, have the same limited liability protection as C corp shareholders, and the same limited liability protections of an LLC if it’s an LLC that elects to be taxed as an S corp. The S corp shareholders’ personal assets, such as bank accounts and homes, generally cannot be seized to satisfy business liabilities.
Just like a sole proprietorship or partnership, an S corp passes through most of its income, losses, and deductions to the shareholders. The shareholders avoid double taxation at the corporate level and again at the individual shareholder level on their personal income taxes. Each shareholder is subject to their own individual tax rate on the income—or losses—passed through to them.
Becoming an S Corp or C Corp
There are several advantages of electing to be taxed as a corporation, especially when it comes to protecting personal assets, transferring ownership, and conducting business accounting.
1. Asset protection
This is a primary reason why small business owners would consider operating as an S corporation or C corporation. The owners and shareholders of an S corp or a C corp have their personal assets protected, even in cases when the company’s assets may be at stake.
2. Pass-through taxation
All business profits and losses “pass through” to an S corp’s shareholders, who have to report it on their personal tax returns. Any losses can offset other income the shareholder has earned, which can be beneficial in the startup phase of a new business when losses are more common.
As a pass-through entity, the tax liability for business income (plus losses, deductions, and credits) goes to the business’s shareholders, the same as it would for a sole proprietorship or a general partnership.
This does not apply to C corporations. Unlike pass-through entities such as sole proprietorships, partnerships, and S corporations, C corporations are separate taxable entities. This means the corporation itself is subject to income tax on its profits. And the shareholders are also subject to tax on any dividends they receive from the corporation.
3. Tax-favorable income characterization
With an S corp or C corp, owners can be salaried employees and receive dividends and other distributions from the business in accordance with their investment in the corporation. The characterization of distributions as salary or dividends can help the owner reduce their liability subject to self-employment income taxes while still claiming deductions for business expenses and wages paid by the corporation.
4. Flexibility in accounting
Business accounting in an S corp uses one of two methods: cash basis or accrual. C corporations must use the accrual method (unless the IRS considers them “small business taxpayers” and they meet the IRS’s gross receipts test).
However, S corps can use the cash basis method, which means that transactions are officially recorded at the time cash is received or paid. This makes their small business accounting and tax planning easier and more straightforward.
5. Transferring ownership
You can sell an S corp and transfer ownership without complicated or costly tax ramifications. An S corp can continue beyond its original owner’s lifetime. This is beneficial for succession planning and when the owner decides to sell the business upon their retirement.
The process of selling and transferring ownership of a C corporation involves several steps and can vary depending on the specific details of the transaction and the corporate structure.
6. Formation process and fees
Electing to be taxed as an S corp involves more steps than forming a sole proprietorship, partnership, or LLC.
You will need to register your business as an LLC or C corp by filing with your desired state of incorporation and paying the associated fees, which vary by state. After you register as an LLC or C corp, you will need to file Form 2553 with the IRS to elect the status of your business and comply with timing requirements.
If a business wants to elect to be taxed as an S corp from the start, it has to do so within two months and 15 days of registering the business. If they decide to do it later, they have to do so within two months and 15 days of the new tax year for it to apply to that tax year.
In addition to the initial registration fee, some states impose ongoing fees, such as annual reports and franchise tax fees. The good news is that these fees are not too expensive and you can deduct them as business expenses. You can learn more about the fees imposed in the state of Oregon here.
7. Stock ownership
An S corp can have only one class of stock but can have both voting and non-voting shares. So the IRS does not permit you to have different classes of investors entitled to various dividends or distribution rights.
Additionally, your S corp can’t have more than 100 shareholders. It also can’t have foreign ownership or ownership by certain types of trusts and other entities. A C corp can have an unlimited number of shareholders but must register with the SEC upon reaching specific thresholds. Unlike S corporations, which have restrictions on the number and types of shareholders, C corporations can have a broad and diverse ownership structure.
This flexibility makes C corporations popular for larger businesses that have numerous investors or want a wide range of shareholders. Keep in mind that the specific rules and regulations may vary by jurisdiction. It’s always advisable to consult with legal and financial professionals to ensure compliance with local laws.
8. IRS audits
The tax-favorable income characterization does come with more scrutiny from the IRS. You can help keep your business from being audited by ensuring that you pay each shareholder-employee a reasonable salary before distributions, that you substantiate all expense reimbursem*nt requests with receipts, and that you always keep accurate records.
9. Limitations
You must meet several requirements to keep your S corp filing status and its associated tax benefits. There are also limitations on who can invest in an S corp business, as there must be fewer than 100 shareholders, among other restrictions. Not complying with these requirements can result in an S corporation being reclassified as a C corporation or an LLC.
If you make any mistakes, you can usually fix them to keep your S corp status. If you decide to change to a C corporation for more flexibility in attracting investors, you can switch business structures from an S corporation to a C corporation. Some stipulations do apply.
One significant drawback, as noted earlier, is the higher overall tax liabilities in comparison with pass-through entities. Additionally, C corps often face more complex and stringent regulatory requirements, including formal documentation, recordkeeping, and compliance costs.
The corporate structure may also be less suitable for small businesses due to its administrative burden and the absence of certain tax advantages available to other business entities.
Making the Right Decision for Your Small Business
Before deciding on your business structure, you need to consider your specific goals and circ*mstances. For professional guidance specific to your situation, contact a qualified tax professional, a legal adviser, or a small business adviser.
At the Oregon Small Business Development Center Network, we help build Oregon’s best businesses. Our 20 regional Centers and Global Trade Center help small businesses throughout Oregon with advising, classes, and access to all the resources they need to be successful.
Each Center has the backing of our statewide support network. This helps small businesses access the right assistance wherever they are in the state. You can connect with your local SBDC at OregonSBDC.org.
Learn more about S corporations, how to become an S corp, and the filing requirements on the IRS website.
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