Advantages & Disadvantages of a C-Corp or S-Corp

By John Cromwell

The U.S. Tax Code and IRS recognize two different types of corporations: the C corporation and the S corporation. The two business types are taxed in two different ways. The C corporation pays taxes on its annual income and then its shareholders pay tax on any dividends they receive from the business. With an S corporation, the business does not pay any tax on its annual income. The shareholders are responsible for paying taxes on their share of the business’s annual income. As a result of this difference in how these organizations are taxed, C corporations and S corporations have different restrictions on several aspects of their business.

Independent Legal Entity

While there are differences, it is important to know that both C and S corporations are independent legal entities. This means two things. First, both corporations operate as a liability shield for the shareholders. If a corporation owes money or acts in a way that injures a third party, the corporation is named as the defendant and the shareholder generally cannot be named as a co-defendant. This protects the shareholders’ personal assets from being seized to satisfy the business’s obligations. Also, both corporations have a perpetual life. This means that neither a C corporation nor an S corporation will terminate when a shareholder dies.

Number of Shareholders

A C corporation has no limitation on how many shareholders it may have, while an S corporation is limited to 100 or fewer. This restriction on the S corporation makes it more difficult for it to raise investment money to grow its business. By having more shareholders, a business can request a smaller amount of money from each individual investor because it can get more investors to obtain what it needs. When asked for less, individuals will be more likely to invest. By asking for more from each individual, an S corporation may risk not getting enough capital or not being able to find investors.

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Classes of Stock

A C corporation can issue multiple classes of stock while an S corporation can only issue one class of stock. Multiple classes of stock can be used as an incentive to attract investors. By issuing preferred stock that gives its holders preference regarding distribution of dividends and other considerations, a C corporation can appeal to certain investors who might be hesitant to invest without additional guarantees. Since an S corporation can only issue one class of stock, it cannot provide those additional guarantees, making it harder to obtain investment.

Identity of Shareholders

A C corporation can sell its shares to any person or entity it chooses. An S corporation can only sell its stock to citizens, resident aliens and certain trusts. This can be a significant barrier for an S corporation, since that restriction prevents it from selling its shares to institutional investors, such as venture capitalists.

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Tax Consequences of Converting a C-Corp to an S-Corp
 

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Subchapter S Corporation Stock Regulations

S corporations are ideal for companies with few owners who would rather report the income on their own tax returns rather than have the company pay the corporate tax. However, S corporations s have strict regulations on the stock issued by the company. Just one violation can trigger a reversion to a C corporation, thereby nullifying the tax benefits granted to an S corp.

Accounting for an S Corporation Shareholder Buyout

An S Corporation is a small business that generally protects its 100 or fewer shareholders from the business’s liabilities. Unlike most corporations, the business income is divided amongst the shareholder to include on their personal returns. This allows the business to avoid “double taxation.” To obtain this benefit, the business must conform to IRS imposed restrictions that limit who can own shares in the corporation. As a result of these restrictions, many of these businesses have established rules regarding when and how a corporation can buy out a shareholder, which ultimately defines how the corporation accounts for that transaction.

The Termination of S Corp Status

S corporation status is an IRS-sanctioned tax designation that allows a corporation to retain liability protection for its shareholders but lets them be taxed like a partnership.This means that the S corporation is not taxed directly, but its shareholders add their share of the business’s annual income and losses to their personal returns and personally pay taxes on those amounts. To choose this status, the corporation must have fewer than 100 shareholders and cannot have any nonresident alien shareholders. It can only have one class of stock and cannot participate in certain industries. A corporation can have its S-corp status rescinded by the IRS or its shareholders can choose to give it up.

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