The S Corporation (‘S-Corp’) and the C Corporation (‘C-Corp’) are two distinct types of corporations. Yes, corporate law can get very confusing, with lots of technical jargon and different requirements per state.
But small distinctions can end up costing a lot of money if you don’t pay attention. Running a corporation is no joke, and comes with a host of legal responsibilities to attend to.
Below, we have outlined a brief history of corporations and what the differences are between the S-Corp and the C-Corp.
An Introduction to Corporations
A corporation is a distinct legal entity established with a particular aim in mind. It is recognized by a nation-state as having specific rights and obligations as its own legal entity. It can own property, get sued, or take legal action.
Various court cases have ensued in disparate jurisdictions that have recognized corporations with distinct legal rights. The most important of these was Salomon v Salomon in 1896. This was a landmark case that set the precedent for others to follow.
There are many distinctions and classes of corporations. One mode of classification is that of profit and non-profit corporations, though the vast majority of corporations are created as for-profit entities.
Typically, a for-profit corporation will be supported by a number of shareholders. These shareholders have stock in the company and a say in its running. In contrast, a not-for-profit corporation will have ‘members’ as opposed to shareholders.
A defining feature of corporations is that the shareholders and members will have limited liability in the event that things fall apart. Personal assets are protected, much like the Limited Liability Company (‘LLC’), a popular model for small, medium, and large business owners.
Major Differences Between Corporations and Other Legal Entities
There is some debate about what kind of legal entity can be called a ‘corporation’, and there are a number of differences between the USA, UK, and Europe in this regard. However, it can be said that a corporation ‘incorporates’, while a company (such as an LLC) is ‘formed’.
Sole Proprietorships and partnerships are not really companies, as they are not required to be registered with a state. They are taxed as sole proprietorships by default as there is no legal distinction between the business and the business owner. This is not the case with corporations, which is why most of them are taxed at the federal level.
In the UK, it is more common to refer to small and medium-sized corporations as ‘companies’ and reserve the term corporation for the very largest business enterprises. In Germany, a legal entity known as ‘GMBH’ bears many features of the corporation, though it is not technically regarded as such. For the purposes of this guide, we will describe the company as the LLC and the corporation as the corporation, which are the most accurate and up-to-date terms to use, with the least confusion.
For more clarity, a table has been created below outlining the major differences between the legal entities.
|S-Corp||Pass-through taxation||Board of Directors, Shareholders||Shareholders||Articles of Incorporation||Limited|
|C-Corp||Double tax||Board of Directors, Shareholders||Shareholders||Articles of Incorporation||Limited|
|LLC||Double tax||Members||Members||Certificate of Formation||Limited|
|General Partnership||Single tax||Partners||Partners||Operating Agreement||Unlimited|
|Limited Liability Partnership||Single tax||Partners||Partners||Operating Agreement||Limited|
|Sole Proprietorship||Single tax||Single Owner||Single owner||None||Unlimited|
|Non Profit 501(c)(3)||None||Board of Directors, Members||Members||Articles of Incorporation||Limited|
What is C-Corp?
C-Corp is the standard kind of corporation. When people use the word ‘corporation’, this is what is meant by default. Corporations (S and C) are governed by the IRS tax code. The S and C refer to the chapters on which the rules surrounding formation are governed.
The C-Corporation rose to prominence in the USA in the late 19th century. Prior to this, large businesses (such as the Carnegie and Rockefeller empires) were established under the Trust model. Now, large multinationals prefer to operate as C-Corporations.
The C-Corp allows limited liability and an unlimited number of shareholders. To register as a C-Corp, certain criteria must be followed. The C-Corp must have a board of directors and must hold annual meetings to disclose the news to shareholders and to resolve any issues. It must also file an annual report in the state where it is domiciled and meet other due diligence requirements. The C-Corp is a public entity, traded on exchanges such as the NASDAQ.
The biggest criticism of the C-Corp is double taxation. It is taxed at the Federal level and the personal income of shareholders is also taxed when dividends are allocated. There is a significant amount of paperwork and maintenance associated with the C-Corp. You will likely be in need of an attorney and an accountant to meet all of the reporting requirements.
What is S-Corp?
The S-Corp is similar to the C-Corp in many ways. It is governed under subsection S of Title 1 the IRS tax code. S-Corporations have been around for about 60 years and there is still a lot of confusion surrounding its attributes. The most dominant aspects of the S-Corp are that:
- The S-Corp is not taxed at the federal level.
- There are more restrictions as to who can be a shareholder.
- There is only one stock type (‘common’).
Aside from this, the S-Corp actually functions very similarly to the C-Corp. It pays taxes, files reports, has annual meetings, a board of directors, and officers that manage the company. It’s important to keep in mind that both the S-Corp and the C-Corp are both corporations. The primary differences lie in how they can hold shares and in the way that the corporations are taxed.
Similarities Between C-Corp and S-Corp
As both of these are corporations, it stands to reason that both have many similar features. Both the C-Corp and the S-Corp confer limited liability. This means that if the company goes bankrupt, the shareholders and board of directors are safe.
Directors of companies are very rarely prosecuted, and if they are it is only for the most severe of negligence or malfeasance. The benefits of limited liability are what led to the rise of the Limited Liability Company (‘LLC’) in the 21st century.
Both kinds of corporations have a similar governance structure. Each has a board of directors (Chief Executive Officer, President, Vice President, Chair, Treasurer, etc) that is responsible for the hiring and firing of officials and workers.
While the shareholders own the corporation, the corporation owns the business. This is a very tricky and important technical point. Also, the board of directors (‘BOD’) is not responsible for the running of the company. They are responsible for the hiring of ‘officials’ (managers) that run the company.
Both kinds of legal entities have practically identical procedural requirements. Both must file annual reports and legal documents. Both need to have registered offices in the states that they do business.
And both structures must perform KYC and due diligence in line with Federal and State mandates. They are incorporated using the same documents, registered with the state (termed the certificate of incorporation or articles of incorporation). The following is a quick summary of the similarities between the two legal entities:
- Both are distinct legal entities that can sue, take loans, get sued, make profits, and own other legal infrastructures.
- Both have shareholders, officers, and a board of directors.
- Both offer limited liability protection to shareholders, officers, and the board of directors.
- All financial accounts are to be kept separate from personal accounts at all times.
- In relevant states, both entities will have to pay Franchise taxes.
- There has to be an annual meeting at least once a year.
- All working owners must be on payroll and pay taxes.
Differences Between C-Corp and S-Corp
So, there are many similarities between the two types. They have the same governance structure, the same procedures, the same reporting obligations, and limited liability. However, there are some subtle differences.
One major point of differentiation is that of tax. With the C-Corp, there is a system of double taxation. This is due to the dividends issued on the stock. The corporations are taxed first, and then the profits are issued to shareholders via dividends (though these dividends are optional and the BOD can reinvest funds into the company).
The shareholders then pay taxes on these dividends. This system of double taxation is one of the primary disadvantages of the C-Corp. With the S-Corp, no income taxes are paid at the Federal level. They are known as ‘pass-through’ taxation entities. All taxes are paid by the owners.
The C-Corp has no restrictions on who can be a shareholder and how many shareholders there must be. The S-Corp is much more restricted in this sense. There can be no more than 100 shareholders in the S-Corp. Only US citizens can become shareholders in the S-Corp.
However, the C-Corp has an advantage in that it can issue multiple classes of stock to shareholders (common stock vs preferred stock) while the S-Corp can only issue common stock. The following is a quick summary of the differences between the C-Corp and S-Corp:
- The C-Corp pays taxes at the Federal level. The S-Corp does not pay federal taxes (taxes passed through to owners on Schedule K/IRS Form 1122).
- C-Corp owners enjoy lots of fringe benefits in comparison to S-Corp owners. These benefits include life insurance and disability insurance.
- Anybody can become a shareholder in the C-Corp. S-Corps are limited to 100 people from the US only.
- C-Corp owners cannot withdraw funds from the company. S-Corp owners can, similar to a sole proprietorship.
- It’s harder to raise venture capital as an S-Corp in comparison to a C-Corp.
Comparison: C-Corp vs S-Corp
To make it easier to understand, we’ve made a table on the differences between the two distinct types of legal entities. This should help you to figure out which one will benefit you the most. Generally, it’s worth bearing in mind that an LLC is more suited to business owners in comparison to corporations. It is easier to manage, less costly to set up, and still confers the benefits of limited liability to owners.
|Taxation||Ownership Restrictions||Stock Classes||Shareholder Rights||Formation Difficulty & Cost|
|S-Corp||Pass-Through||100 members, US only||Common Only||Restricted||Identical|
|C-Corp||Double Taxation||Unlimited, Anywhere||Common or Preferred||Broad||Identical|
C-Corporations: Advantages and Disadvantages
The primary advantages of the C-Corp are limited liability and prestige. Limited liability is an essential motivating element in setting up a legal entity structure. Unlike the partnership of the sole proprietorship, the assets of shareholders and directors are safe in the event of business failure. Nobody is going to come after your house or personal goods. You are not held accountable and don’t pay anything from your own pocket. In the event of bankruptcy, creditors cannot sue shareholders to recuperate assets.
Another benefit is that corporations have unlimited life spans. Long after the founding members die, the corporation will live on. This is in contrast to sole proprietorships and partnerships, which are often dissolved when the members pass away. There is less risk in this regard, as the business is not tied to one or two core people.
Another major advantage of the C-Corporation is that of prestige. If you are looking to raise equity or impress some venture capitalists, then the C-Corp is the way to go. It can be listed on international stock exchanges and is afforded a lot of legal protection. This makes it comfortable for investors. They can purchase stock and will then have a say in the running of the corporation. They can also sell their stock if they wish without any restrictions.
The primary disadvantage of the C-Corporation is double taxation. What happens is that the corporation is taxed at the state level and dividends are also taxed on the shareholders’ personal income statement. As per the 2017 corporate tax Act, the tax rate stands at 21%.
S-Corporations: Advantages and Disadvantages
The S-Corporation enjoys all of the advantages of the C-Corp and many of its disadvantages. It allows for limited liability and a lot of prestige. At the same time, there are lots of regulatory filing, meetings, and compliance issues to attend to. There is a lot of hassle involved in running a corporation, whether it is a C-Corp or an S-Corp.
The biggest advantage that the S-Corp has is that it is only taxed once, on the income statements of the shareholders and board of directors. This means that the 21% Federal income tax is completely bypassed. Shareholders pay taxes on dividends through Form 1040.
But an additional benefit is that S-Corp shareholders can claim a 20% tax reduction. If $100,000 is earned in dividends, only $80,000 will be taxed. This is only for certain eligible businesses, presently ones that earn less than $157,000 (single) or $315,000 (joint).
But this tax advantage comes at a large cost. The S-Corp can only have 100 shareholders, and these are restricted to US citizens. Unlike the C-Corp, the S-Corp cannot issue preferred stock. Preferred stock is a stock that comes with certain privileges against the common stock – perhaps they get paid first, or have more rights at meetings. The S-Corp can only issue common stock.
The corporation is not merely reserved for huge enterprises but has a number of niche uses. Setting up an S-Corp can be a great idea for consultants and other business types. However, the Limited Liability Company is invariably a better option, as it offers tax benefits without the shareholder restrictions.
S-Corp status can be taken away if it does not adhere to the legal requirements. The IRS can revoke its status, and will do so when the shareholders grow above 100, are from a different county, or issue more than one type of stock.
Setting Up Your Business As a C-Corp
Setting up your business as a C-Corp requires a lot of work. As a quick summary of setting up your C-Corp:
- Choose your State of Incorporation
- Register a Corporate Name
- Identify the Board of Directors
- Create Corporate bylaws
- File the Articles of Incorporation
It’s important to select your state of incorporation wisely. Typically, it will simply be the state where you intend to do business. But you also have the option of ‘Foreign Qualification’, where you set up a registered office in a different state (often Delaware) to avail of special protections and lower taxes. However, this comes with additional complexities and you have to pay to open a registered office in this state. Annual fees can also vary greatly, from $60 in Colorado to $800 in California.
In some states, foreign qualification is known as ‘Certificate of Authority’ or ‘Certificate of Registration’. Foreign qualification is done at the time of company formation. It can get complex, so it is best to consult an attorney.
Filing for Incorporation
The process of actually filing the Articles of Incorporation for a C-Corp is quite easy. You can do it online and will get approval within 2 days. The Articles are only a single document with essential corporation details such as the board of directors, address, telephone, etc. You can find the articles on the Secretary of State website (for whatever state you are doing business in). You can often perform a business name availability search on the same website.
Other steps you may need to take to set up your C-Corp might include:
- Getting an EIN number from the IRS website.
- Setting up a corporate bank account.
- Holding the first meeting of directors
- Issuing stock to shareholders.
- Filing a fictitious name (‘DBA’).
Keep in mind that you simply set up a corporation (or LLC) first. The ‘S’ or ‘C’ designations are assigned after you elect for tax status and hold your annual meeting. If you wish to do business in a different state, then you may wish to file for a Doing Business As (‘DBA’). This is the branding name you will be operating under in a different state, just in case your business name is not available there.
Of course, if you are doing business in a different state, you will need to have a registered office there and meet additional reporting requirements. So you should only do this after giving it a great deal of thought. For additional information on starting a business, check out this guide.
Setting Up Your Business As an S-Corp
To get set up as an S-Corp, you have to set up a corporation or LLC first. After you have done this, you can opt for S-Corp status by filing an IRS Form 2553. This must be filed before the 16th day of the third month of the year. If the form is not filed by this time, then the S tax status will only take effect the following year. Just be mindful of the IRS eligibility requirements:
- The business must be domiciled in the USA
- Shareholders cannot include partnerships, corporations or non-resident alien shareholders;
- The S-Corp must have fewer than 100 shareholders.
- The S-Corp can only have one stock (‘common stock’).
- The corporation must be eligible (certain financial institutions, insurance companies, and domestic international sales corporations are forbidden the S-corp architecture).
You can migrate your LLC to an S-Corp as well. The process is similar, in that you would have to file an IRS Form 2553 before the 16th day of the third month of the year. Remember that you can always change your status back to an LLC or an S-Corp. The S-Corp was originally created for those who wished to bridge the gap to corporation status but needed an intermediary step to grow and expand.
Other Kinds of Corporation
C-Corp and S-Corp are not the only types of corporations. Some other formats include:
Professional Corporation – This is a corporation consisting of professionals in a licensed profession (such as doctors, lawyers, accountants, etc). Only professionals in the industry can become shareholders. This allows them the benefit of limited liability, which is very important in professional areas due to the high rates of negligence claims. Another option for working professionals is a limited liability partnership.
Non-Profit Corporation – This is a charitable organization that reinvests all of the proceeds for the furtherance of its goals. Non-profits typically have aims in social humanitarian, educational, or artistic areas
Closely Held Corporation – This only has a small number of shareholders that is listed to the public. It trades infrequently. These corporations are not at risk of hostile takeover due to the tight ownership.
As mentioned earlier, many people consider LLCs to be incorporations, but this is technically incorrect. Using the technical language found in the IRS tax code (which is the Bible for business law), the company is a company, a partnership is a partnership, a sole proprietorship is a sole proprietorship, and a corporation is a corporation.
The C-Corp and the S-Corp are elite legal entity models, affording limited liability, and prestige. But both come with a huge level of IRS scrutiny and strong reporting requirements.
Small business owners earning less than $100,000 a year would be best advised to opt for LLC status, which is cheaper to create and easier to manage.
Corporations are best suited to those with big plans such as venture capital or long-term expansion on a large scale. For more information on the different legal entity models and potential financing options, get in touch with a Finimpact representative.