When starting a business, one of the most important decisions the business owner must make is whether to form a business entity, like a corporation or LLC. If the business owner decides to form a corporation, the next decision is how should the corporation be taxed for income tax purposes. There are two choices—it can be a C corporation (meaning the corporation pays income taxes) or an S corporation (meaning the shareholders pay taxes on their share of the corporation’s income instead of the corporation paying income taxes).
Corporations: An overview
The difference between a C corporation and an S corporation is the way they are taxed. When you incorporate you will notice that nowhere on the Articles of Incorporation does it mention S corporations or C corporations. The state corporation law you form under doesn’t distinguish between S corporations or C corporations. It’s the IRS that cares, not the state corporate filing office.
S corporation vs. C corporation: The similarities
Here are some things to know in general about a corporation, whether it is taxed as an S corporation or a C corporation:
- Limited liability protection. Corporations offer limited liability protection, so shareholders (owners) are typically not personally responsible for business debts and liabilities.
- Separate entities. Corporations are separate legal entities created by a state filing.
- Filing documents. Formation documents must be filed with the state. These documents, typically called the Articles of Incorporation or Certificate of Incorporation, are the same regardless of whether you choose to be taxed as an S corporation or C corporation.
- Structure. Corporations have shareholders, directors
andofficers. Shareholders are the owners of the corporation. But it is the corporation that owns the business. The shareholders elect the board of directors, who in turn oversee and direct corporation affairs and decision-making but are not responsible for day-to-day operations. The directors elect the officers to manage daily business affairs.
formalities. Corporations are required to follow the internal and external corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder and director meetings, maintaining a registered agent and registered office, filing annual reports, and paying annual fees.
- Foreign Qualification. If the corporation transacts business in states other than its state of incorporation, it will have to qualify to do business in each of those states, and meet certain other requirements like maintaining a registered agent and office, filing annual reports, and paying annual fees.
S corporation vs. C corporation: The differences
Taxation: For small business owners evaluating S corporations vs. C corporations, the decision comes down to how they want the corporation to be treated for federal income tax purposes.
- C corporations. C corps are separately taxable entities. They file a corporate tax return (Form 1120) and pay taxes at the corporate level. They also face the possibility of double taxation
ifcorporate income is distributed to business owners as dividends, which are considered personal income. Tax on corporate income is paid first at the corporate level and again at the individual level on dividends.
- S corporations. S corps are pass-through tax entities. They file an informational federal return (Form
1120S), but no income tax is paid at the corporate level. The profits/losses of the business are instead “passed-through” to the business and reported on the owners’ personal tax returns. Any tax due is paid at the individual level by the owners.
- Personal income taxes. With both C corporations and S corporations, personal income tax is due both on any salary drawn from the corporation and from any dividends received from the corporation.
Corporate ownership: As we mentioned, the state corporation laws make no distinction between S and C corporations. However, the Internal Revenue Code does have a number of requirements that a corporation must meet in order to elect taxation under subchapter S.
- S corps are restricted to no more than 100 shareholders, and shareholders must be US citizens/residents. C corporations have no restrictions on ownership
- S corporations cannot be owned by C corporations, other S corporations (with some exceptions), LLCs, partnerships or many trusts.
- S corporations can have only one class of stock (disregarding voting rights), while C corporations can have multiple classes.
C corporations, therefore, provide a little more flexibility when starting a business if you plan to grow, expand the ownership or sell your corporation.
How to become a C corporation (C Corp)
Actually, you don’t “form” or “become” a C corporation or an S corporation. You form a corporation—period. And you do it by filing a document, generally referred to as Articles of Incorporation (sometimes called a Certificate of Incorporation) with the state and pay filing fees.
Before you do, you have to choose a name (after first determining that it is available to you) and choose your corporation’s registered agent. Both the corporation’s name and its registered agent have to be included in the Articles of Incorporation.
After the incorporation process is completed, you will need to fulfill other requirements. These include adopting bylaws, holding an initial meeting of directors and shareholders, and issuing shares of stock to owners. Your corporation will be taxed under Subchapter C unless you qualify for, and elect to be taxed under Subchapter S.
How to become an S corporation (S Corp)
If you want your corporation to be taxed under Subchapter S after the Articles of Incorporation are filed, you will need to file Form 2553 with the IRS. The IRS instructions—which can be a bit tough to follow—require that an election is considered effective in the current tax year only if the Form 2553 is completed and filed:
- Any time before the 16th day of the 3rd month (for
calendaryear taxpayers, this means it needs to happen by March 15th)
- Any time during the preceding tax year (however, an election made no later than 2 months and 15 days after the beginning of a tax year that is less than 2½ months long is treated as timely for that year).
Generally, an election made after the 15th day of the 3rd month but before the end of the tax year is effective for the next tax year (unless you can show
Keep in mind that some states also require you to file a state-level S corporation election after incorporating your business.
What if you want to change how your corporation is taxed?
When you first incorporated your business you had to choose whether your corporation would be taxed as a C Corp or an S Corp.
But what if you later change your mind? This can happen either because your business changed, or the tax laws changed, resulting in your corporation being better off taxed differently than before. A lot of small businesses were reevaluating whether they should change from S corporation tax status to C corporation tax status, or vice versa, when a new tax law (The Tax Cuts and Jobs Act of 2017) was passed. This law made significant changes including reducing the corporation tax rate (which favored C corporations) and providing a special 20% deduction for pass-through entities (which favored S corporations that qualified for it.) There were lots of other changes too.
Tax laws are complex. And consulting with tax advisors will help you make the best decision as to how your corporation should be taxed, both at the time of incorporation and later on.
Choosing between C Corp and S Corp: Which is best for your small business?
Your choice of entity structure has a big impact on many aspects of your business, ranging from taxes to financing to growth strategies. Looking at the differences between your options may help you come to a decision that best suits your unique business needs and goals.
To help you see which business type might be best for you, try our Incorporation Wizard. This tool allows you to compare different business types by key considerations such as industry, income, future plans, and more.