Whether you’re starting a new venture or are looking to reclassify your current entity’s tax status, it’s important to consider the differences between an S Corporation (“S-corp”) and a C Corporation (“C- corp”). Both structures provide unique tax benefits and ownership capabilities. The best fit for your business will require both financial and legal advice to investigate the advantages of each.
Overview of C-Corp
The C-corp is the default classification for incorporated business entities and is the common structure for publicly traded companies. C-corps are also attractive for startup founders who seek to raise capital from a variety of sources. Your C-corp is a separate entity with its own assets. It realizes net income or loss, pays taxes at the corporate level, and may share after-tax profits with the owners via dividends. Ownership of the corporation is unlimited, which we’ll dive into further below. LLCs have the option to be taxed as a C-corp, but we would discuss the legal implications of INC vs. LLC with your corporate attorney.
Benefits of C-Corp
Structuring your business as a C-corp can be extremely attractive once you consider your business model, funding sources and exit plan. One benefit exclusive to C-corps when compared with S-corps is unlimited ownership. The C-corp can be owned by an unlimited number of shareholders. Shareholders can be domestic, foreign, individuals, corporations, partnerships, trusts, etc.
The C-corp sets its authorized number of shares and can have different classes of stock. The most commonly issued stock shares are “common”, which are standardized voting shares and eligible for dividends. Stock can also be issued as “preferred”. Preferred stock can provide “preferred” dividends and other privileges. Preferred stock can have several subclasses, but it is primarily issued to attract certain types of investors or leverage control of the company. With all this ownership flexibility, there are many diverse avenues to secure funding for corporate projects and operations.
Another potential advantage to a C-corp is the qualified small business stock (“QSBS”) exclusion. If the C-corp is a qualified small business (“QSB”) by the Internal Revenue Code at the time of issuance, there can be some significant tax benefits for investors when that stock is sold. The tax treatment for QSBS depends on how the stock was acquired and how long it was held, but if requirements are met, the sale can have a capital gains exclusion of up to 100%. You can pay zero tax on your exit of up to $10M (or more). For investors who sell their QSBS before the end of the required five year holding period, they may be able to defer the tax treatment by investing the proceeds in another company’s QSBS within 60 days.
You’ll find taxes listed under downfalls of a C-corp below, but with proper planning and timing, the C-corp tax regime can actually be an advantage. The current C-corp tax rate is 21%, compared to the top tax rate of 37% for S-corp shareholders. It’s important to note, the QBI deduction can bring the S-corp shareholder’s rate down to 29.6% with proper planning. This is only available for non-SSTB businesses. For SSTB businesses, a C-corp can be an effective vehicle for deferring taxes. Paying 21% tax now and kicking the can down the road can be attractive for high growth companies vs. paying current taxes at 37%. It’s important to note, the second layer of tax will hit when the profits are distributed. Assuming qualified dividend treatment, the rate can be anywhere from 0-23.8%. Profits cannot be held in the C-corp to intentionally delay paying the dividend tax. You can only keep what is ordinary and reasonable inside the corporation or you run the risk of being assessed the accumulated earnings tax. Depending on the trajectory of the company and growth plans, keeping a large cash reserve may be considered reasonable. One final thought on C-corp taxes is to remember the step up in basis that is afforded heirs at the time of death. This can be a powerful mechanism to transfer C-corp stock and take the bite out of the second layer of tax.
Downfalls of C-Corp
The C-corp does have some downfalls, especially when compared to the S-corp. A major disadvantage of the C-corp is double taxation, which occurs when the C-corp pays corporate taxes on it’s own tax return and then distributes the remaining post-tax profits as dividends. The distribution of earnings and profits are taxable on the shareholder’s personal tax return. Although the corporate rate was reduced to a flat 21% by the Tax Cut and Jobs Acts of 2017, corporate tax rates are historically much higher. We always preach flexibility and having multiple entities allows you to pivot in the future based on regulation changes. Assuming a 21% corporate tax rate and a 23.8% dividend tax rate, the effective total tax rate would be 39.8% in today’s environment. With a 35% corporate tax rate, the effective total tax rate would increase to 50.5%.
C-corps can result in some painful tax consequences for an asset sale of your business. For one, C-corps do not have a preferential capital gain rate. Assuming no QSBS exclusion is available, you’ll end up paying tax at the 39.8% rate discussed in the paragraph above. Compare this to an S-corp shareholder likely paying only 20% on their multi-million-dollar exit. Factors like depreciation recapture and other ordinary income treatment may push this 20% up in some cases, but overall, the tax savings on exit is astronomical. Locking yourself into a C-corp should only be done with a concrete exit plan. Ideally this includes qualifying for the QSBS exclusion or selling the business in a stock sale.
Overview of S-Corp
Created in 1958, the S-Corp was designed to tax all profits at the shareholder’s individual tax rate. No corporate taxes are paid at the federal level. It’s important to recognize that the S-corp is not a legal entity. It is purely a tax classification, created to encourage and support the creation of small and family businesses. An LLC or and INC can elect to be taxed as an S-corp.
To elect S-Corp status for a new business, Form 2553 must be filed within two months and 15 days of the effective date for the election to take effect. For existing businesses wanting to elect S-Corp status, they can also file up to two months and 15 days after the start of the applicable tax year OR they can file the election at any point during the preceding year. This 2.5 month deadline creeps up on taxpayers regularly. Luckily, the IRS allows late election relief via Rev Proc 2013-30 if you meet the relatively relaxed requirements.
Benefits of S-Corp
A major benefit of the S-corp is that it provides for pass-through income to the shareholders, preventing the double taxation dilemma involved with C-corps. There is no federal income tax paid at the corporate level, leaving only a single layer of tax which is paid by shareholders on their allocated share of income. Avoiding double taxation is not the only benefit available to S-corp shareholders. They also escape self-employment tax on their share of the corporation’s profits. Owners who also work as employees of the S-corp must be paid a “reasonable compensation” via a salary, and that compensation is subject to FICA taxes as well as ordinary income tax.
Beginning with the Tax Cuts and Jobs Acts of 2017, there is also a deduction for Qualified Business Income (QBI). This is a deduction of up to 20% of the QBI from an S-corp which conducts a trade or business in the US. This deduction is one that can be claimed by the taxpayer whether the taxpayer itemizes their other deductions or not. This can bring down the tax rate you pay on K1 income from 37% to a net 29.6%. The QBI deduction does have specific limitations, so consult your CPA or professional tax advisor.
In the event of an asset sale of your business, you’ll benefit from capital gains treatment. The character of income inside the S-corp passes out to your individual level. For a business in which you materially participate, you may avoid the 3.8% net investment income tax (NIIT). These are both huge factors to keep your tax on exit down close to 20%.
Many businesses suffer losses in the first few years in business. If your business is taxed as a C-corp, there is no current benefit from your NOL. If you are taxed as an S-corp, you may be able to offset your other income and your spouse’s income on your individual return. There are passive loss, basis and at-risk limits that need to be considered. For the typical founder who starts a business with their own funds and puts a substantial amount of time into the business, the loss will be allowed. If your loss is funded with third-party debt, you may be better off taxed as a sole proprietorship or partnership. We’ll save that for another post, but the deductibility of early losses is an advantage when compared to the C-corp.
Downfalls of S-Corp
S-Corps have inherent limitations that need to be considered. S-corps have restrictions when it comes to ownership. They are restricted to a maximum of 100 shareholders and can issue only one class of stock. The S-corp shareholders must be US residents for tax purposes. S-corps cannot be owned by C corporations, other S corporations (with some exceptions), LLCs, partnerships, or most trusts. As a result, this restrictive and limited ownership structure can make it difficult to raise money for the business.
Another consideration with S-corps is phantom income. Taxes must be paid on income when it is earned, even if no money is distributed to the shareholders. If you’re an S-corp owner and are planning to avoid paying taxes on your earnings this year by not taking distributions, you’ll want to come up with a new strategy. Cash flow and taxable income do not always match and careful attention needs to be paid to avoid a tax bill and no cash to pay it.
Profits interests are not available for S-corps but you can consider a partnership structure with S-corp shareholders. S-corps require distributions to be made pro-rata and require all income and losses to be allocated pro-rata. Partnerships allow for specially allocated profits and losses, and disproportionate distributions. We’ll touch more on partnership vs. S-corp in a separate post, but these are factors to consider before diving into the S-corp structure.
What This Means for You
It can be difficult to choose between being a C-corp or electing the S-corp option, and that choice might not be obvious without a full investigation. The points described in this article are just a few highlights of the differences and some important things to keep in mind when deciding which option best for your business. For a comprehensive evaluation, specific to your company and situation, it would be wise to consult with a CPA experienced in guiding business owners through these decisions.
If you’d like assistance navigating these decisions, feel to contact us here. We’d love to speak with you to see if we are the right team to help you.