When incorporating a business in the United States, one of the primary decisions is whether to choose an S Corporation or C Corporation. While these two types of corporations have some commonalities in their basic structure, there are also some important differences to be aware of.
These differences primarily pertain to taxation and ownership requirements. The right type of corporation to choose will depend on the specific situation and needs of the business.
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A corporation is one of the most common types of business structures, along with Limited Liability Companies, Sole Proprietorships, and Partnerships. In order to form a corporation, you must prepare a document known as the “articles of incorporation” and file the relevant registration documents with state authorities. Owners of a corporation are known as shareholders, who elect directors to oversee and run the business.
The profits of a corporation are distributed as dividends to its shareholders. A corporation is a separate legal entity which offers limited liability protection to its owners. These basic features of a corporation are common for both S Corps and C Corps.
S Corporations and C Corporations have many features in common, including:
The main differences between an S Corp and a C Corp can be broken down into three categories.
All newly formed corporations are automatically designated as C Corporations when you file the articles of incorporation. The only way to form an S corporation is to convert an existing C Corporation by filing form 2553 with the Internal Revenue Service (IRS).
Depending on the state, there may be additional state forms to file in order to be granted S Corp status for tax purposes. The consent of all shareholders is required to convert a C Corporation into an S Corporation.
In terms of formation requirements, a C Corporation is naturally simpler as it requires less paperwork and no additional complexity to convert it.
The primary benefit of an S Corporation over a C Corporation is taxation.
C Corporations are effectively subjected to double taxation because they are treated as separate legal entities for tax purposes by the IRS. This means that the C Corporation itself incurs corporate income tax on its profits. These after-tax profits are distributed to shareholders as dividends, which in turn incur dividends tax on each shareholder's personal tax returns.
S Corporations, on the other hand, allow the owners to avoid this double taxation. S Corps benefit from “pass-through” taxation, whereby all profits and losses are passed directly to the shareholders and are therefore not taxed at the corporate level. The shareholders are directly liable to pay taxes at the personal level. This is similar to the taxation structure of a sole proprietorship or partnership, but with the limited liability benefits of a corporation.
Importantly, fringe benefits provided to shareholders (e.g., life and disability insurance, health cover, etc.) are not tax-deductible in the case of an S Corp, but may be for C Corps.
The primary benefit of a C Corporation over an S Corporation is greater flexibility in ownership.
A standard C Corporation does not have any restrictions on ownership. The corporation can have an unlimited number of shareholders, issue various classes of shares, its owners can reside anywhere in the world, and can be any legal or natural entity.
In contrast, a corporation that chooses to convert to an S Corp has a number of ownership restrictions:
The greater flexibility in ownership enjoyed by C Corporations makes them more ideal for larger companies looking to expand globally, or to offer multiple classes of shares to a large number of investors.
The owner restrictions of an S Corporation are only a disadvantage if it does not align with the objectives of the business and shareholders.
Deciding on whether to stick with a C Corporation or have your business converted to an S Corporation is dependent on your situation and specific requirements. There are a number of factors to consider before making the final decision:
The aforementioned factors should help you to make an informed decision about whether an S Corporation or C Corporation is best for you.
Overall, an S Corporation is the preferred choice for smaller businesses who already fit within the legal restrictions of an S Corporation, as it can help them to save on taxes without any structural changes to the business. C Corporations are preferred by larger businesses who wish to expand globally and have a large number of shareholders.
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*Note for U.S. citizens: US citizens are limited in their tax reduction possibilities due to FATCA and CFC laws. Opening an offshore company can increase privacy and asset protection, but you can not eliminate your taxes without giving up your citizenship. If you are a US citizen you are obligated to pay taxes on all worldwide income. Read more here about FATCA and CFC laws.
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