C Corps and S Corps: Key Tax Differences
When entrepreneurs start a business, choosing the right business entity is crucial. Two common choices are S corporations (S corps) and C corporations (C corps). A corporation may have pass-through taxation or double taxation, depending on whether it is a C corporation or an S corporation. This is because the Internal Revenue Code allows for two different levels of corporate tax treatment. Subchapters C and S of the Code define the rules that apply to corporate taxes.
This article provides a basic summary of the tax differences between C corporations and S corporations. Each has unique tax implications that can significantly affect a business. Understanding these differences helps business owners make informed decisions.
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The C Corporation
C corps are traditional corporate structures. They are considered a separate legal entity from their owners. For tax purposes, C corps pay corporate income tax on their profits. This is known as business tax. After paying corporate income tax, if a C corp distributes profits to shareholders as dividends, these distributions are taxed again on the shareholder's personal tax returns. This is often referred to as double taxation. More specifically, corporations file their tax returns and pay taxes on profits before paying dividends to shareholders, which are subsequently taxed on the shareholders' individual returns.
C corps file taxes using IRS Form 1120, the corporate tax return. They must adhere to specific bylaws and maintain a board of directors, which decides on the distribution of dividends. Shareholders have voting rights based on their shares of stock.
The S Corporation
S corporations enjoy the same benefits and must observe the same formalities required of C corporations but are not subject to double taxation. S corps provide limited liability protection, safeguarding personal assets from business debts. They also avoid double taxation, a benefit for small-business owners.
S corps are considered pass-through entities for tax purposes. This means the business income is passed through to the owners' personal tax returns and taxed at their personal income tax rate. There is no separate business tax at the corporate level. This can lead to significant tax savings.
To qualify for subchapter S tax treatment, a corporation must:
- Be domestic (meaning all U.S. citizens or residents)
- Have a limited number of shareholders (100)
- Have only one class of stock
- Not have any corporate or partnership shareholders
- Not have nonresident alien shareholders
- Not be an ineligible corporation, such as insurance companies or certain financial institutions
Additionally, after a business is incorporated, all shareholders must agree to subchapter S treatment before electing that option with the IRS. Please keep in mind that the limitations imposed by the subchapter may affect the transferability and marketability of corporate shares.
The Main Differences Between C Corps and S Corps
The following are the key differences between each of these business types:
- Tax Status: C corps are subject to corporate income tax and potential double taxation. S corps are pass-through entities, avoiding corporate income tax.
- Distribution of Profits: C corps face double taxation on dividends. S corps pass profits directly to owners, who pay personal income tax.
- Self-Employment Tax: S corp owners can save on Medicare and Social Security taxes, as their distributions are not subject to self-employment taxes.
- Number of Shareholders: S corps have restrictions on the number of shareholders allowed. C corps do not.
- Tax Filing Requirements: C corps file a corporate tax return. S corps report income on owners' personal tax returns and an annual report to the IRS.
Choosing between a C corp and an S corp involves considering tax implications and legal requirements. Consulting with a tax professional or legal adviser is advisable.
Learn More About Your Corporate Tax Obligations: Talk to a Lawyer
If you would like help determining if a C or S corporation is right for your business, or you have any other questions about starting or operating a business, you could benefit from a consultation with a qualified tax lawyer. Professional assistance can make the difference between a solid and durable business structure and one that exposes you to unintended liability.
Lawyers can guide you in filing the necessary paperwork and registering with the state. They can also help discern how your chosen business type will impact a business's tax responsibilities and savings. Entrepreneurs must weigh these factors alongside their business goals, startup needs, and long-term vision for their company.
Contact a local tax law attorney today and learn how they can help you put together a corporate structure that best meets your needs.
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