S-corp or C-corp? Which Entity Should you Be?
Published on by Andy Bertke in Tax Services
Both S corporation (S-corp) and C corporation (C-corp) structures share many common benefits; however, there are several notable differences that could have a direct impact on your business. Some of these differences can be an advantage or disadvantage, at any time, for either structure. Here’s a quick summary of what you should know about your structure:
The most noticeable difference between an S-corp and a C-corp is with respect to taxes. The two most important differences are:
- Income of an S-corp is taxed at its respective shareholder(s) rate, whereas a C-corp has its own corporate tax rate, and;
- Upon liquidation or a distribution of earnings, an S-corp for the most part, has one level of tax, whereas a C-corp has 2 levels of taxation.
Additionally, not only are there different tax rates, an S-corp and a C-corp handle many tax items differently:
- An S-corp passes income or loss to the shareholders:
- Passing income to the owner subjects the income to the graduated tax rate of the owner. The highest individual rates range from 10% to 37%.
- Under the new tax law in effect now, and depending on the type of business, S-corp income is reduced by 20%. This reduces the individual rates from 10% to 37% to 8% and 29.6% closing the gap between its C-corp counterpart.
- Income from the S-corp can be spread among multiple owners thus lowering the income to each owner; therefore, potentially lowering the overall tax rate.
- Losses are passed through to the owners and can be used to offset income from other sources on the owner’s individual tax return.
- An individual is also subject to alternative minimum tax (AMT) which eliminates or adjusts the timing of various tax deductions allowable for the regular tax calculation.
- Has one level of tax. Generally cash distributions (dividends) are not taxed again at the owner’s level, or when the corporation liquidates.
- A number of items are separately passed through to the owners and create significant tax differences:
- Charitable contributions passed through to the owners are subject to the individual limitations, some contributions are limited to a high of 60% of the individual’s adjusted gross income.
- Long term capital gains are passed through and are taxed at the individual’s long term capital gains rates which range from 0% to 20%.
- Tax credits pass through to the owner and offset the individual tax, dollar for dollar.
- A C-corp incurs income and loss at the entity level:
- A C-corp has a flat tax rate of 21%. However, in some cases C-corp taxes were lower before the new law due to the graduated tax system of the prior law.
- There are no preferential capital gains rates as all types of income are taxed at 20%
- The new tax law eliminated AMT tax system.
- Charitable contributions are limited to 10% of taxable income. However, there is an enhanced deduction for certain contribution made by C-corps.
- State tax rates can vary, and in some states corporate rates are lower than the individual tax rates, and the opposite is true in other states.
- Double taxation occurs when a C-corp pays a dividend, or when the corporation sells its assets and liquidates.
- In certain instances, a C-corp enjoys tax benefits upon sale of stock, such as deferral of gain when stock is sold.
Both entities share the same allowable tax accounting methods and other rules and regulations, but not all. For example:
- Ownership is limited to certain types of individuals and entity types.
- The fiscal year end is generally limited to a calendar year, although an exception can apply.
- There can only be up to 100 owners in an S-corp.
- An S-corp can only have one class of stock; therefore, it cannot have common and preferred shares.
- Setting compensation too low can cause scrutiny from the IRS.
- Some employee benefits, for owners, are not deductible at the corporate level.
- Setting compensation too low can cause IRS scrutiny.
- In general, there are no restrictions on who can be an owner, and there is no limit on the number of owners.
- For the most part, a C-corp can choose its fiscal year.
- A C-corp can have more than one class of stock.
- Setting compensation too high can cause scrutiny from the IRS.
Just like a product or a service, a corporation has a life cycle, and that life cycle can dictate what entity structure is best at a given time during its life. For example: at startup, a business has losses; therefore, a pass-through entity (S-corp) can pass those losses through to the owners to offset other income and help recover the investment the owner made from reduced taxes. Alternatively, a business owner may want to use their IRA to fund the startup of the business. If so, you need to have a C-corp structure.
As the company stabilizes and begins to produce income, and wants to use that income (cash) to purchase assets/resources to promote growth, a C-corp with its low 21% tax rate could be the best entity choice.
When the owners want to sell the business, there are wildly different results between both entities. The main difference stems from whether the owners sell the assets of the company, or the stock of the company. In the myriad of alternatives, a C-corp or S-corp could be the best solution. There are also various estate plans can facilitate the structure of the company, where some plans are better executed with one structure over the other.
There is not a one size fits all solution to the question: “should I own an S-corp or C-corp?” Luckily, and subject to some restrictions and potential tax pitfalls, a business can choose different structures along the way. To determine what structure your company should be, and when, can only be determined based on current facts and circumstances, along with a very good idea what the owner’s plans are with the company for the next 5 and 10 years.
Finally, it is important to note that there are numerous items to take into consideration before changing entity type, the acid test related to measuring the current income tax of either structure is to “follow the cash”. If the shareholder(s) are going to strip the company’s earnings out through payroll and distributions, then generally an S-corp would be structure of choice. On the other hand, a strong argument can be made for a C-corp structure if the company is in growth mode and income will be retained to fund expansion.
Do you want to talk entity structure with a Barnes Dennig specialist? Let us know here, and we’ll connect you with a team member at no charge, or let us know by calling 513-241-8313.
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