Should I Choose an S or C Corporation for My Small Business?

It’s a critical decision for New Jersey startup owners

By Doug Mentes, Esq.

Once a small business owner decides their business should incorporate, the decision-making is not complete. Included in that decision is which form of corporation should the owner choose. Should it incorporate as a C Corporation or S Corporation?

By default, any business startup will form as a C Corporation under IRS rules. The business must designate to form as a subchapter S corporation by filing IRS Form 2553 – Election by a Small Business Corporation. The entity form is called an S corporation because the law allowing it is found under subchapter S, Chapter 1 of the IRS code.

Regardless of the choice, the first step for New Jersey business startups is to register their corporation with the state—by filing Articles of Incorporation. Part of that process will be designating which form of business entity the owners choose. New Jersey business owners electing to register as an S Corp must apply and obtain approval for that status from the state of New Jersey, separate from filing the election with the IRS.

Why choose an S Corporation?

Small businesses chose to form as a S Corp because of tax savings. Like sole proprietors and partnerships, S Corporations are flow-through entities, meaning the income is not reported at the corporate level, but flows through to the owners who report their business income as personal income.

Compare that to Income earned by a C Corporations, which does not flow through and is taxed at the corporate level. If the C Corp then distributes that income as dividends to the owners, or shareholders, those dividends are taxed as personal income to the owners. This is referred to as double taxation; avoiding it is the reason to choose the S Corporation structure. However, this does not eliminate the possibility of paying state corporate income tax to New Jersey for some S corporations. A quick review of corporate and individual income tax rates will demonstrate the clear tax benefit for small business S corporations.

Why chose a C Corporation?

With election of a S corporation comes several requirements on those businesses, including:

  • No more than 100 shareholders allowed
  • Can only issue one class of stock share
  • All shareholders must be U.S. residents
  • Cannot be owned by a C Corp, other S Corporation, LLC, partnerships and many trusts
  • Fringe benefits to employees are often not tax deductible

None of these restrictions apply to C Corporations which gives the C Corp form much more flexibility over the S election. For example, C Corporations can issue different classes of stock that will allow the business to take on investment without granting shareholder voting rights to certain classes. The business can also solicit investment from foreign sources, giving it more access to raise capital, and it’s not limited to 100 shareholders. Also, C Corporations are more motivated to offer better fringe benefits to employees—like health insurance and disability coverage—because those benefits are deductible.

Similarities?

Both forms still offer limited liability, meaning owners and shareholders are personally protected from liabilities of the business. There is also the entity form of Limited Liability Companies (LLCs) to consider. LLCs are not corporations and are a more recent creation meant to offer the advantage of limited liability to those formed as sole proprietors and partnerships.

In 2018 and going forward, tax reform will have an impact on both S and C Corporations—both business forms likely seeing their tax burdens decrease—although the tax cuts given to S corporations sunset, while the tax cuts to C Corporations remain permanent. Determining which type of corporation to form is an important decision for the business. Small businesses should consult with an experienced New Jersey business attorney to ensure their business is set up for the greatest possible success.

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