Today, I’ll be comparing the C-Corp vs. S-Corp tax classifications. You will have come across both of these terms as you structure your business, and it’s important to know the difference!
Before you read anything, understand this:
The first, and most important, item is that the terms “C-Corp” and “S-Corp” do not refer to business entities. These are in fact tax classifications, elected by a business, and subsequently reviewed by the IRS. Understanding and choosing the correct classification will help save your business’ hard-earned money.
C-Corp vs. S-Corp
By default, all corporations are taxed as a C-Corporation. C-Corps experience what the IRS calls “double taxation.” When earned, profits are taxed first at the corporate level. When these profits are distributed to shareholders in the form of dividends, they are taxed again.
Well, that doesn’t sound like much fun! Actually, for a small business, double taxation can be avoided. More on this in a moment.
There are many instances when C-Corp status is appropriate, especially in large companies. For example, if the benefits of deducting employee contributions and income splitting outweigh the costs of double taxation, or if annual corporate profits exceed $250,000 per owner (a general rule of thumb**), C-Corp classification makes sense.
Fortunately for a small business, there is relief in the form of S-Corp, or “Subchapter S Corporation,” status.
With S-Corp status, the tax on corporate profits passes through to the shareholders’ personal income statements. This means an S-Corp is taxed once, at the owners’ income tax rate. S-Corp status also allows you to split your profits into “shareholder profits” (subject to employment tax) and “distributive share” (not subject to employment tax). Owners pay tax on the “reasonable salary” they pay themselves, but can realize tax savings on the rest of their retained profits. The rule of thumb** here is that if annual corporate profits are between $75,000-250,000 per owner, S-Corp classification makes sense.
There is a common misconception that “S-Corp” stands for “small business corporation.” An S-Corp is permitted a maximum of 100 shareholders (to the C-Corp’s unlimited number), however, so that may be a helpful device to remember which is which.
So how do I become an S-Corp?
A corporation or LLC can make a special election to the IRS, by filing IRS Form 2553 within 75 days of the beginning of the entity’s tax year. There is no cost to file the form, although the IRS estimates you’ll spend 16 hours researching and preparing the form. Late filing is permitted; however, the IRS requires a Reason for Late Filing, and they can reject your application. Currently, the IRS is processing Form 2553 in about 2-3 months.
How do I become a C-Corp?
If you incorporated, you are taxed by default as a C-Corp, and you do not need to file anything!
However, it is possible, though way less common, to elect C-Corp status. An example is an LLC electing C-Corp status. In this way, the LLC will be taxed separately from its members, and as such, business income will not appear on the member’s personal income statement. This offers a degree of asset protection and financial privacy for the member.
To elect C-Corp status, you need to file IRS Form 8832, which is very similar to Form 2553. You can elect C-Corp status either as a new entity, or make a change to the existing classification.
There is no fee, and several hours of research are necessary. Again, filing late in the tax year is permitted, but you’ll need a legitimate reason.
Do I have liability protection?
If you’re weighing the decision between C- or S-Corp, you have either a corporation or an LLC, which are business entities. As long as the entity itself is in good standing, you’ll have limited liability protection, regardless of tax classification.
Again, whether you should be an LLC or corporation, or taxed as a C-Corp vs. S-Corp, is a business decision. Always consider your revenue, resources, and plan for growth. If you need help deciding or filing, please contact us!
**Please contact an accountant for taxation and financial advice on your specific situation