In the simplest terms, the only real difference between an S- and C- corporation is a tax election. All corporations are initially formed as C- corporations. In fact, an S- corporation is merely a C corporation that within 75 days of formation has made a 2553 tax election to be treated as an S- Corporation for tax purposes. Let there be no misunderstanding, all corporations are initially formed as C Corporations, by filing incorporation documents with the state of incorporation, enacting by-laws, issuing shares, and holding the first meeting of the Shareholders and Board of Directors. Once the business has been incorporated and the shares have been issued, the shareholders (owners) of the corporation may decide whether or not to file the 2553 federal S-Election so the income, or losses, of the corporation pass directly through to the shareholders' (owners') individual 1040 tax returns. The S-Election must be made and filed within approximately 75 days of incorporating, or the corporation will remain a C- corporation until the following year when the shareholders will have their next opportunity to file the 2553 S-Election. Again, filing the 2553 S-Election does not, and will never, create a different type of corporation; the S-Election merely changes the tax structure of the corporation.
C- corporations are required to pay a 15% tax on retained corporate income or profits. In addition, if the C corporation pays a dividend to its stockholders (owners) from the corporation's retained earnings, the dividend must be included on the stockholders' personal tax return. Therefore, the profits of a "C" corporation are subject to possible double taxation — once at the corporate level (15% or 25%) and again on the stockholders' individual personal tax returns.
An S- corporation is a C- corporation that has made a federal 2553 tax election to be treated as a sole proprietorship or partnership for tax purposes. With S- Corporations all income and losses are "passed-through" to the individual shareholders, who then report their pro-rata share of the corporation's income, or losses, on their individual tax returns. The S corporation itself does not pay any income tax, but S corporations with more than one shareholder (owner) still must file an informational tax return like a partnership or LLC, to report each shareholder's portion of the corporate income. Attorneys and other qualified tax specialists often recommend that their clients form a Subchapter S corporation, and while this is most often the right choice occasionally such an election may cost the client a lot more in tax dollars.
Advantages To Electing S Corporation Status.
There are several major federal income tax advantages to making the 2553 federal S-Election, including:
- Single Level Tax. Corporate profits and losses are passed through to the shareholders (owners) of the corporation thus eliminating the potential for the "double taxation" faced by C- corporations;
- Net Losses Can Be Deducted On Personal Income Tax Returns. While the losses of a C- corporation can only offset the corporation's earnings, the net operating losses of a S- corporation can be passed through to the individual shareholders and deducted on their individual tax returns in the year the loss occurs; and
- Minimization of Self-Employment Tax and FICA. With a S-Corporation, the shareholders can minimize both self-employment and FICA taxes by creating a balance between salary and dividends. Dividends (the corporate profits distributed to the shareholders) are not subject to either self-employment tax or FICA.
The single most critical tax planning issue for corporations is not whether to make the 2553 S-Election, but creating a balance between the corporate officer's salary (reported wages on the W-2) and corporate dividends ("distribution of profits.") The distribution of profits is not subject to the FICA taxes, unemployment taxes, workers compensation insurance (if applicable), or any other employment related expenses.
Disadvantages To Electing S- Corporation Status.
Despite the many advantages listed above, S- corporations cannot avail themselves of the following benefits afforded to C- Corporations:
- C- Corporations may exclude up to 50% of the gain on the sale of "qualified small business stock;"
- Shareholders of C- Corporations may avail themselves of tax-free fringe benefits such as health and accident insurance, while S Corporations are prohibited from deducting the costs of fringe benefits provided to shareholder-employees who own more than 2% of the outstanding shares;
- C- corporations can have more than 100 shareholders, while S corporations must have less than 100 shareholders;
- C- corporations can be owned by other corporations, non-resident aliens, LLCs, and other S- corporations, while S- Corporations can only be owned by individuals, estates, and certain qualified trusts;
- The shareholder-employees of a C corporation are scrutinized less by the IRS, while those same shareholder-employees of an S- Corporation are scrutinized to ensure they receive reasonable compensation (wages subject to employment taxes) before any non-wage distributions (dividends) may be made to them; and
- Unlike a C- Corporation that can deduct and carry forward all losses, an S corporation shareholder may not deduct corporate losses that exceed his or her "basis" in the corporate stock, which equals the amount of the shareholder's investment in the corporation plus or minus a few adjustments.
When a C- Corporation May Be Better.
Personal service corporations are subject to a flat tax of 35% regardless of their income, and in such cases shareholders are almost always best off electing S- corporation status. However, personal holding corporations are subject to only a 15% tax on the $50,000 of undistributed income, and 25% tax on the next $25,000 of undistributed income. With our country's "progressive" tax rate structure, nominal personal income tax rates go from 10% to 15%, 25%, 28%, 33% and 35% with actual effective rates much higher despite the innumerable tax breaks enacted during President Bush's tenure. If the individual shareholders are in the upper income brackets, they should strongly consider remaining a C corporation and foregoing the 2553 S-Election. High income shareholders who have elected S status will find they are required to pay income tax on their share of the corporation's income whether or not they take the money out of the corporate account. Consequently, if a corporation is not a personal service corporation and if its owners of the corporation are in the higher income tax brackets, the shareholders of that corporation may be better off remaining a C- corporation.
Once an S election is made, it applies for all succeeding years unless and until the shareholders of the corporation unanimously agree to terminate the election, or the election is involuntary revoked because the corporation ceases to satisfy the eligibility requirements for S status (e.g, the S corporation's stock is acquired by a nonqualified shareholder such as a corporation or the number of shareholders exceeds the maximum permitted). Corporate shareholders preferring pass through taxation because the individual shareholders are not in the top income brackets, or because the shareholders expect initial business losses and desire to take such business losses on their individual tax returns to offset other income earned, should unanimously elect S corporation status. Fortunately, if you make the 2553 S-Election and later decide there are more tax advantages to being a C corporation, the shareholders can vote to terminate the S-Election and convert back to C corporation status.