When incorporating your business structure as a C-Corp, LLC or partnership, you’ll be faced with an important decision—whether to be taxed as incorporated or elect to be taxed as a S-Corp. This choice has big implications for how much you’ll pay in taxes, your ability to raise money, and the ease with which you can expand your business.
Initially, S corporation is not an entity. It is a taxation election. The original and underlying entity must be one of the above, so all information related to S Corp truly relates to the underlying entity being treated as an S Corp for taxation purposes. A tax election only, this election enables the shareholder to treat the earnings and profits as distributions and have them pass through directly to their personal tax return. The catch here is that the shareholder, if working for the company, and if there is a profit, must pay him/herself wages, and must meet standards of “reasonable compensation”. This can vary by geographical region as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit. If you do not do this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for all of the payroll taxes on the total amount.
It can be hard to understand the differences between C-corporations vs. S-corporations. Fortunately, the differences come down to three main areas: formation, taxation, and ownership. The last two are the most important. In most other aspects, S-corps and C-corps are similar.
Formation: The most basic difference between S-corps and C-corps is formation. The C-corp is the default type of corporation. When you file articles of incorporation with your secretary of state, your company will become a standard C-Corp. S-Corp is not a legal business entity per se but rather an entity strictly for taxation purposes which must be elected. A C-Corp or LLC can elect to be taxed as S-Corp by electing such status with the IRS. After filing the form, you will become an S-Corp for federal tax purposes but for legal purposes your business is still recognized as originally formed, a C-Corp or LLC. You might have to file additional papers at the state level to be treated as S-corp for state taxes.
Taxation: Taxation is the main difference when comparing C-corps vs. S-corps. Many business owners elect S-Corp classification to save on taxes.
C-corps are subject to “double taxation.” First, the C-corp is taxed at the corporate level when the company file a corporate income tax return. A C-corp can then be taxed again, on the owners’ personal income tax returns, if corporate income is distributed to the corporation’s shareholders as dividends.
Under a S-Corp, shareholders/owners report their share of the business’ income and losses on their personal tax return. This is called pass-through taxation. As a shareholder of a S-corp, your business’s income ‘flow-through” and is taxed on your personal income when filling Form 1120S.
Ownership: C-corporations have no restrictions on ownership. Unlimited number of shareholders, as well as different classes of shareholders are the main perk to form a C-Corp. Venture capital firms and investors prefer to hold preferred stock in a corporation, which is only an option for C-corps, severely limiting capital raising as an S-corp. S-corporations are limited to one class of stock, meaning that there’s only one kind of shareholder. There’s no hierarchy or difference between shareholders of the business,
S-corporations can have only up to one hundred shareholders. Shareholders of an S-Corp must be United States citizens or legal resident aliens, whereas C-corps doesn’t have this restriction and are open to foreign investors. An S-Corp can’t be owned by a C-Corp, other S-corps, LLCs, general partnerships, or most trusts. Other corporations, LLCs, or trusts can own C-corporations.
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Common questions for S-Corp
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Pass-through taxation. The taxation structure of a S-corp is unquestionably its biggest benefit. S-corps don’t have to pay taxes on the business’s income twice. Avoiding double taxation is a huge benefit for those smaller businesses with enough profit to share dividends among its shareholders/owners.
Deduction of business income. The recent tax act plan allows owners of S-corps and other pass-through entities to deduct 20% of their business income on their personal tax return, which can significantly reduce your tax burden.
Avoid Double Taxation. S corporation is taxed as a disregarded entity and does not have to pay corporate-level taxes. Instead, the corporation passes its profits and losses through to its shareholders to be taxed at an individual tax rate. Therefore, Income is taxed only once. Besides the distribution of profit, shareholders can pay themselves a reasonable salary for the work conducted for the business saving on self-employment taxes. For more information on tax advantages, get a free consultation.
Tax filing requirements. Owners of S-corps can write off their business’s losses on their individual tax returns. This is a benefit for newer corporations that are likely operating at a loss for the first few years. As the owner, you can write off the losses of the business on your personal income statements, offsetting your income from other sources.
IRS Compliance. Election status with the IRS is mandatory within 75 days of business incorporation and possibly additional state paperwork to elect S-corp status. A late relief is available past the timeline requirement. It is also closely monitored by the iRS due to the potential for abuse hence the stringent compliance rules.
Limited ownership. Unlike C-corps, S-corps have ownership restrictions limited to Citizens and legal residents and 100 shareholders to maintain S-Corp status and avoid penalties. This stances an issue for high-growth projected businesses or businesses looking to conduct business internationally.
Limited stock flexibility. S-corps also preclude from issuing preferred stock and different classes of stock, one type of stocks is allowed which can make it harder to raise money from investors and incentivize initial owners.
Tax qualifications. Generally, S-corps are susceptible to have more IRS scrutiny. Iif there is a mistake filling your return or not meeting compliance guidelines, the IRS may terminate the S-Corp status and the business will be taxed as a C-Corp.
Administrative Overhead. Payroll and Payroll taxes return need to be submitted on a monthly or quarterly basis. Also, tax return form differs from an LLCs or sole proprietorship with added accounting cost. These are likely to be offset by the tax savings an S-Corp offers.
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