S Corporation vs. C Corporation: Breaking Down Different Tax Requirements for New Corporations
- Jan 13, 2022
Choosing the entity type of your new business can be complex and overwhelming. Learn the differences in tax requirements and qualifications and see which is the best fit for you.
Tim schuster: Can you tell me about S-corps and C-corps and what some of the differences are?
Corporations can generally be broken down into two categories: there are C corporations or regular corporations (think of Apple or Johnson and Johnson) that are just referred to as corporations, and S corporations. A C corporation is treated separately from its owners in all respects including income taxes (unlike an S Corp, which we'll get into), the shareholders are not liable for any debts of the corporation so the owners have liability protection. A corporation however pays tax on its own income and after paying that tax if a corporation pays dividends of after-tax profits to its shareholders that dividend is also subject to tax at the individual level. In this way the corporation is subject to double taxation - once on its earnings at the corporate level and again when the shareholder receives a dividend. Now despite this considerable tax disadvantage for a new business corporations are often the entity of choice for those who seek to raise significant capital through third-party investors.
S corporations remain a very popular entity type, particularly for small businesses. They are also corporations and can have more favorable tax treatments than a regular corporation. The shareholders have liability protection just like in a corporation, however there's no corporate level tax, and the income flows through to the individuals so that they pay tax on their share of the company’s earnings on their individual income returns. They also receive some favorable tax treatments in respect to Social Security and Medicare taxes which, depending on the profitability of the entity, can be substantial. Now the Social Security and Medicare tax savings are not available to all other types of flow-through entities, partnerships and LLC’s, so this is still an entity type that is very common and popular. There is also a provision in the Tax Cuts and Jobs Act that potentially allow a 20% deduction, called Qualified Business Income Deduction (“QBI”), to the shareholders of the company. QBI is complex and not all business qualify for the QBI deduction. Shareholders would need to discuss QBI in detail with their trusted advisor. If a business does qualify a simple example of this would be if you are the single shareholder of an S-corporation and the bottom line taxable profit that you would need to report on your personal return is 100K. You, as a shareholder, could potentially receive a 20K deduction on that 100K of income, effectively paying tax on 80K of income rather than 100K.
Despite the popularity of S-Corporations, there are limitations which can be very prohibitive depending on the intent and plan of the business. Only one class of stock is allowed in an S corporation and as a result all shareholders are treated equally with the ownership percentage dictating the distribution of earnings and profits, not only tax ability but distribution - you cannot take money out of an S corporation in any other proration other than your ownership percentage. That can often be problematic in terms of governance. Additionally S Corporations have restrictions on who may be shareholders and how many shareholders there may be. All shareholders must be US citizens and only certain trusts are eligible shareholders of an S corporation, and there can't be more than a hundred shareholders. Partnerships and corporations cannot qualify as shareholders. So while these while these factors are not necessarily an issue for all small businesses if the company anticipates that it's going to be raising venture capital money in the future an S corporation may not be the best choice. A general overview of tax law can be very complex and we advise that anyone considering choice of entity to consult with their trusted advisor.
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Mr. Schuster is a Senior Manager providing tax compliance services to individual filers, as well as assistance on tax returns for companies in the manufacturing and real estate industries.
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