If you’re a small business owner or an aspiring entrepreneur, establishing your company as a corporation can be an exciting part of growing your business. However, there are a few things to consider when deciding which type of corporation you should establish, and that decision will have long-lasting effects.
Most business owners eventually will be tasked with deciding whether they should organize their company as a C-corporation or an S-corporation. Before deciding which path is right for you, however, it’s important to understand the differences between the two corporation types and the pros and cons of each.
What Is a C-corporation?
C-corporations are companies whose individual shareholders own the business. This type of organizations can have an unlimited number of investors. After a C-corporation is organized, a board of directors is formed by the shareholders and strategic company directions are created and prioritized, including the hiring of company leadership. C-corporation owners have limited liability protection, guarding their personal assets in the event of legal battles.
What Is an S-corporation?
S-corporations are very similar to C-corporations in that shareholders, the board of directors and company officers all have the same responsibilities and limited liability. However, S-corporations are able to take advantage of pass-through taxation. This allows owners to report the company’s profits and losses on their own individual tax returns. Unlike C-corporations, however, S-corporations are limited to no more than 100 shareholders and may not consist of partnerships, corporations or non-resident alien shareholders.
How to Form a C-corporation
In order to form a C-corporation, there are several steps that need to be followed:
- A legal business name needs to be chosen and filed with your secretary of state.
- Articles need to be filed with the secretary and corporate bylaws will be drafted by a board of directors. After article acceptance, stock certificates will be issued to stakeholders.
- Apply for a business license.
- Submit proper forms to the IRS and get assigned your Employer Identification Number (EIN).
How to Form an S-corporation
S-corporations can only be formed once a C-corp is established. All businesses that are C-corporations can elect to become an S-corporation; however, there are some rules to follow before conversion:
- The board must approve the transition from a C-corporation to an S-corporation.
- Tax year needs to be changed to an approved format.
- New filing forms need to be completed and submitted within 75 days of corporation formation.
- The business must only have 100 shareholders or less (a family of shareholders can count as one).
- Corporations can only have one form of stock.
- Meet certain shareholder type restrictions.
The Pros and Cons of C-corps vs. S-corps
When deciding which type of corporation is right for your business, there are several pros and cons associated with each:
Some Tax Benefits. C-corporations are able to deduct the cost of employee benefits such as health insurance and disability.
Unlimited Shareholders. There is no limit on the number of shareholders in a C-corporation, nor are there limitations to non-resident investors. This is the ideal scenario for companies doing business overseas.
Limited Liability. Investors and employees are protected from business debts and obligations, specifically from legal issues.
Double Taxation. Any profits are subject to double taxation. They are subject to corporate income and when profits are distributed as dividends, shareholders will need to pay a second tax they report on their personal returns.
Corporation Maintenance Fees. Each year, corporations must pay fees to maintain their status.
Pass-Through Taxation. One of the largest benefits S-corporations provide is the ability for owners to report their profit shares and losses on their individual tax returns.
Less Tax Filing Requirements. Unlike C-corporations, which are required to file their taxes quarterly, S-corporations are only required to file annually.
Limited Ownership. Unlike C-corporations, which allow unlimited shareholders, S-corporations are limited to only 100 shareholders in the organization.
No Non-Resident Shareholders. The shareholders of S-corporations must be U.S. citizens or permanent residents. This is unlike C-corporations, which are open to all types of investors.
Fundraising in C-corps vs. S-corps
Each corporation type has some differences associated with how it can raise capital for the business.
C-corporations can issue different classes of stock. This flexibility allows for more variations in the number of protections and preferences available for potential shareholders. Typically, C-corporations are easier to raise money for, since investors are protected with limited liability.
While S-corporations prove to be more challenging to raise capital for, many companies still choose to invest in S-corporations in order to benefit from the pass-through tax treatment. However, due to the limited shareholders allowed and only one class of stock available, S-corporations provide significantly fewer benefits to potential investors over a C-corporation.
Choosing the Right Type of Corporation for Your Business
When choosing the right type of corporation for your business, there really is no right and wrong choice, as you will need to decide what’s right for your company.
That being said, C-corporations are typically chosen by organizations that need maximum ownership and tax flexibility, along with liability protection. They are also best suited for companies doing business with investors overseas and have the need for a large number of investors.
While S-corporations are more restrictive to investments and only allow U.S. resident shareholders, they provide the benefit of pass-through taxation of income while still maintaining liability coverage for all shareholders.