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

Once a small business owner decides their business should incorporate, the decision-making isn’t over. The next critical step is to choose which form of corporation and business structure is best for them. S corp vs. C corp?

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 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. Business owners electing to register as an S Corp must apply and obtain approval for that status from their state, separate from filing the election with the IRS.

Why Choose an S Corporation?

Small businesses choose 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 corporation, 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 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.

What Are the Requirements for Getting S Corporation Status?

Electing an S corporation entails several requirements, including:

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

Why Choose a C Corporation?

None of the restrictions listed above apply to C corporations, giving 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 its number of shareholders isn’t limited to 100.

Also, C corporations are more motivated to offer better fringe benefits to employees—like health insurance and disability coverage—because those benefits are deductible on IRS tax returns.

Are There Similarities Between S Corps and C Corps?

Both forms still offer limited liability protection, meaning owners and shareholders are personally protected from the 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.

Determining which type of corporation to form is an important decision for any small business. Consult with an experienced business attorney to ensure your business is set up for the greatest possible success.