Incorporating a business creates a separate legal entity and protects shareholders with limited liability. However, a corporation can be either a C corporation or an S corporation. An S-corp is a C-corp that has made a special election. The differences relate to who can be a shareholder and how the company and shareholders pay taxes on the business's profits and losses.
C-corps face double taxation, which means that the corporate profits are taxed once at the corporate level and then a second time when the dividends are paid out to the owners. S-corp, on the other hand, are pass-through entities, which allows them to avoid double taxation. Instead, the profits and losses from the S-corp are reported on the shareholders' individual income tax returns each year, regardless of whether any distributions are paid out or not.
S-corps have several significant restrictions on shareholders. First, an S-corp can't have more than 100 shareholders, although family members can be counted as just one shareholder for purposes of the 100-shareholder limit. Second, the shareholders must be U.S. citizens, U.S. residents or certain qualified trusts and estates. An S-corp can't have a partnership, corporation or non-resident aliens as shareholders. C-corps on the other hand, have no limitations on who can own stock or how many owners it can have.
S-corps are also restricted to having just one class of shares. That means that an S-corp can't have one set of shares with higher divided payments or liquidation priority. However, an S-corp can have voting and non-voting stock without losing the election. C-corps aren't restricted as to how many classes of stock it can have, so it can have some shares that receive higher payouts, some with higher liquidation preferences and others with more control over day-to-day activities, if it so desires.
Unlike a C-corp, S-corps can't engage in certain businesses. For example, certain financial institutions, insurance companies and domestic international sales corporations aren't allowed to be S-corps. In addition, if a C-corp elects to be treated as a S-corp more than 75 days after it starts, it could face extra taxes on the build-in gain in the company when it converts.