Corporations are some of oldest business structures in the U.S. and the flexibility and corporate veil protection they offer to owners and shareholders is unmatched. Unfortunately, they can also be the most complicated businesses to qualify for, form, and maintain. In this 3rd installment of our “Choosing the Right Business Structure” series, we provide an in-depth examination of the pros and cons of S Corporations and C Corporations.
The biggest advantage of an S Corporation (S Corp.) is that it has a tax structure similar to C Corporations, but with liability protection akin to LLCs. Many business owners are not aware of the benefits a S Corp can offer and thus, fail to take advantage of them. S Corps will not work for every business, nor will every business qualify. Still, we discuss their core advantages and disadvantages below.
An S Corporation is a corporation that chooses to pass its corporate income and loss as well as tax deductions and credits through to its shareholders/owners for federal tax purposes. By doing this, they avoid double taxation and report all gains and/or losses on individual tax returns. Additionally, FICA taxes also known as self-employment applied to Social Security and Medicare are only counted against earnings paid to owner-employees, the remainder of the net earnings is counted as dividend income.
Another advantage of an S Corp is that it provides limited liability protection, regardless of tax status. Limited liability protection means that the owners’ personal assets are shielded from the claims of the business’ creditors.
Salary and Dividend Payments
Since the dividends are not subject to FICA, an S Corp owner can choose to receive both a salary and dividend payments from the corporation. The corporation can also deduct the cost of the wages paid when computing the amount of income that is passed through to the shareholders. However, claims involving the division between salary and dividends are heavily scrutinized by the IRS, so be sure they are reasonable.
If S Corp shareholders want to reclassify to a C corporation, they need only complete a few simple filings with the IRS.
Not every LLC is eligible to become an S Corp, however. Some limitations are as follows:
- Corporations located outside of the U.S., some insurance companies, and some financial institutions are ineligible
- There must be less than 100 shareholders and those shareholders only can only be comprised of certain eligible categories of individual, trusts or estates.
- Lastly, S Corps are limited to a single stock class, though this class can contain both voting and non-voting stock.
Here are some of the challenges of being an S Corp, as well as some issues that are inherent in operating as a corporation, as opposed to LLCs which tend to be more flexible.
In order to be eligible to incorporate as an S Corp. your business must meet strict requirements on the number and type of shareholders as well as types of shares. These requirements are mandated by federal tax law. It is important to note that an LLC can be a pass-through entity for taxes purposes without having to adhere to these restrictions, so that is something consider along with the needs of your business.
Profit and Loss Allocation
An S Corp is required to apportion profits and losses among owners based firmly on the percentage of ownership or number of shares that particular owner holds. As opposed to an LLC that is able to distribute its profits and losses in whatever amounts the owners’ wish. For example, an owner who transfers 50 percent of his ownership interest to a new member could still receive a disparate share of the income in an LLC. Meanwhile, in an S Corp, the owner’s allocation would be decreased from 100 percent to 50 percent.
S Corps must adhere to numerous corporate formalities imposed by Florida’s corporations’ statutes, Florida LLCs, however, are subject to far fewer statutory formalities.
The following are some of the advantages that a C Corporation (C Corp) has over other business structures.
As with most other business structures, except sole proprietorship, C Corps enjoy limited liability. If a C Corp is formed and operated with legal guidelines and if corporate formalities (i.e. having separate bank accounts, holding meetings, and keeping minutes), the owners should be entitled to protection. It is worth mentioning though that if a corporate officer or shareholder does something negligent or personally guarantees a corporate debt, then the corporation will not protect them creditor or legal action. If a court disregards a corporate structure and allows the owners to be held personally liable, it is known as piercing the corporate veil.
There are several tax advantages that are available only to corporations, such as: insurance for families may be fully deductible; Tax-deferred trust can be set up for a retirement plan. Losses are fully deductible for a corporation.
In a sole proprietorship, when the owner leaves or dies without a succession plan, the assets may be transferred to their heirs, but in order to continue the business the new owners would need to establish a new business structure. Similarly, in partnership would result in dissolution or reorganization. With a C Corp, there is the ability to exist forever. Owners and shareholders can change in perpetuity without affecting the business.
C Corps issue shares of their stock to the people or entities who want an ownership interest in the corporation. Shares can come with varying rights in the corporation, depending on its assigned class, for example, common stock or preferred stock. Stock distribution also allows the owners of a business to share the profits of a business without relinquishing control.
A C Corp and all of its assets may be transferred easily with the assignment of a stock certificate.
Financing and Credit
- Raising Capital – A C Corp may raise capital by selling stock or borrowing money, the added benefit is that they do not pay taxes on money raised through stock sales.
- Separate Credit Rating – A C Corp is afforded its own credit rating. As such, the business can go bankrupt, yet the shareholders’ personal credit will remain unmarred and vice versa.
The name of a C Corp often sounds more like a large, professional operation than a sole proprietorship. Though a legitimate business name and probably also be achieved with a partnership or LLC.
A C Corp is much more complicated to operate than most other types of business structures, given the required formalities in how a corporation is managed.
A C Corp pays corporate income tax on its income, after accounting for losses, deductions, and credits. Then, it pays its shareholders dividends from the after-tax income. The shareholders then must pay personal income taxes on those dividends. This means that the same income is taxed twice on the corporate and individual level.
As you can see, there are several advantages and disadvantages to operating as an S Corp and a C corporation. Capital Partners Law can help you evaluate if either of these corporate entities are a good fit for your business and its future growth.
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This article is for informational purposes only. It does not create an attorney-client relationship with any reader nor should it be construed as legal advice. If you need legal advice, please contact our firm.