C Corporation versus S Corporations: Making Sense Of Your Choices
When you choose to incorporate a business, you do need to consider the “C corporation versus S corporation” question.
The right choice can save you both money (usually in the form of income or employment taxes) and headaches…
Unfortunately, I can’t provide exhaustive treatment of the “C corporation versus S Corporation” question here. However, I can provide you with a bird's-eye view. And I can provide some useful general rules you can use as you begin your analysis of the decision to choose between these two corporate tax accounting treatments.
Primer on C Corporations and S Corporations
Okay, here’s the big, essential feature of a C corporation: A C corporation pays the federal and state government income taxes on the income the business earns.
And here’s the big, essential feature of a Subchapter S corporation, also known as an S corporation: An S corporation typically pays no federal or statement income taxes on the income it earns. Rather, the people who own the business pay the income taxes on the business’s profit.
Let me give you an example of how this works using the imaginary business, Acme Corporation, so you see what I’m talking about. Suppose that Acme Corporation makes annual business profits of $200,000.
Example of How C Corporation Taxation Works:
If Acme Corporation is a regular corporation, called a C corporation for tax purposes, it would typically first pay a state corporate income tax on its profits. Different states charge different corporate tax rates, but a good guess might be that the state in which Acme does business will levy a 5% state corporate income tax, or $10,000 /A 5% tax on $200,000 equals $10,000/.
In addition, the federal government would also levy a federal corporate income tax on the net income after paying the state corporate income tax, equal to roughly $60,000.
Those taxes might be all the taxes the C corporation pays. However, if the C corporation distributes the “net of taxes” profits (roughly $130,000) to shareholders, those shareholders pay another individual income tax on the dividends. Currently, the dividend tax equals 15% at the federal level and, typically, a smaller amount (say 5%) at the state level.
A corporate dividend of $130,000, then, might also mean that the corporation’s owners pay another $25,000 in income taxes.
After paying federal and state corporate income taxes and then federal and state individual income taxes on dividends paid out to owners, the business owners might receive roughly $105,000 of the $200,000 of profit. Roughly half of the business profit would be paid to the federal and state government through taxes.
Example of How S Corporation Taxation Works:
To start, let me make a quick tangential comment: An S corporation is called an S corporation because the rules for making the S corporation election are specified in Subchapter S of the Internal Revenue Code. What’s more, regular corporations that haven’t made an S election are sometimes called C corporations because the rules for taxation of regular corporations are specified in Subchapter C of the Internal Revenue Code.
And now, back to the example…
Suppose that Acme Corporation continues to make annual business profits of $200,000, but makes an election with the Internal Revenue Service (and as needed with any state revenue agencies) to be treated as an S corporation. In this case, the corporation doesn’t pay federal or state income taxes.
The owners of the corporation, however, will pay ordinary federal and state income taxes on the corporate profits.
Suppose, for example, that Peter and Tom, two brothers, own Acme Corporation as fifty-fifty shareholders. Each brother will need to include on his personal tax return $100,000 of the corporation’s profit. And note that it will not matter whether Acme actually pays out the profits to the shareholders.
If the brothers and Acme are located in a state with a 5% individual income tax, that would mean that each brother would pay $5,000 in state individual income taxes on the $100,000 share of corporate profit that flows out to the shareholder’s personal return.
In addition, the federal government would also levy a federal personal income tax on the net income after paying the state personal income tax. Federal individual income tax rates vary, but a good guess might be that the brother would also pay a 28% federal income tax equal to roughly $27,000.
Summing up, each brother would pay roughly $33,000 in tax on his $100,000 share of the corporate profits, meaning each shareholder brother would receive roughly $67,000 of profit after taxes. Roughly one third of the business profit would be paid to the federal and state government through taxes.
Remember that with the C corporation tax accounting (discussed earlier), Acme and its owners paid income taxes equal to roughly half of its business profit. In comparison, with an S corporation, Acme and its owners pay only a third of their profits in federal and state income taxes rather.
Benefits of a C Corporation (Versus an S Corporation)
While you might think, based on the preceding discussion that an S corporation automatically and always beats a C corporation, choosing the better corporate tax treatment is trickier than that.
Experienced business owners and entrepreneurs may choose the C corporation tax treatment for the following reasons.
Growing through reinvested corporate earnings:
As the preceding discussion of C corporation tax treatment indicates, the dividend tax paid by the owners of the corporation is only levied at the point that dividends are actually paid out to the shareholders.
If a corporate plans to retain earnings to fund growth, a C corporation may not cost that much more in taxes on a current basis than an S corporation does. And do note that if a corporation earns and reinvests modest amounts of profit in the business, the tax rates may be lower than what I used in the example above. The first $50,000 in profit that a C corporation earns may be subject to a low 15% federal corporate income tax.
Tax-free fringe benefits for shareholder-employees:
Small corporations often employ their owners--which raises an interesting tax planning opportunity. A C corporation can provide tax-free fringe benefits to employees, including shareholder-employees.
In other words, the corporation can make pension fund contributions or buy health insurance for employees. These expenditures are tax deductions for the corporation. But the benefits aren’t taxed to employees.
For many of these fringe benefits, by the way, the corporation needs to be non-discriminatory in the way it treats employees. With a pension plan, for example, the corporation needs to treat shareholder-employees and non-owner employees consistently.
With some fringe benefits, however--such as accident and health insurance--the C corporation may be able to discriminate, thereby providing shareholder-employees with generous tax-free income in the form of fringe benefits.
Failure to qualify for Subchapter S Corporation status:
Even if a corporation would benefit from being treated as an S corporation, the corporation may not be able to use S corporation tax-accounting rules.
Subchapter S corporation status was designed by the U.S. Congress for small, simple corporations. In order to be eligible to make an S corporation election, a corporation needs to have a small number of shareholders (generally less than 100 shareholders) who are all either U.S. citizens or permanent residents. Further more, the s corporation must have only a single class of stock.
Benefits of an S Corporation (versus a C Corporation)
Business owners typically choose S corporation status for a couple of reasons:
Avoiding double taxation on corporation profits:
Reason one for electing Subchapter S status is to avoid the doubling effect of paying both corporate and individual income tax.
As noted above, by avoiding federal and state corporate income taxes, the shareholders do end up paying more in personal income taxes than they would otherwise.
However, when you “do the math” and consider the total taxes paid on the business profits at both the corporate and individual level, an S corporation commonly (but not always) saves income taxes.
The double taxation effect, by the way, was precisely what caused the imaginary Acme Corporation, used in the earlier examples, to pay income taxes equal to half of its profits when operating as a C corporation but pay income taxes equal to only a third of its profits when operating as an S corporation.
Saving on employment taxes:
A second popular reason to operate an active trade or business as an S corporation comes from employment tax rules.
To understand this reason, you need to understand that with small corporations, shareholder employees commonly attempt to extract (and are often successful in extracting) all of the corporation’s profits in the form of salary paid to shareholder employees.
Consider, for example, the imaginary Acme Corporation discussed earlier. Acme Corporation can “solve” its corporation income tax problem by paying an extra $100,000 in wages or year-end bonuses to each of its two shareholder employees, Peter and Tom.
Paying out the $200,000 will mean that the corporation profit and therefore corporation income tax bill drop to zero. Of course, the two shareholder-employees will see their personal incomes jump by $100,000 each. But in a sense, this bookkeeping approach (which is available many times to C corporations) solves the double tax problem.
The problem is employers and employees pay not just income taxes but also employment taxes on wages. These employment taxes equal roughly 15% on the first $100,000 of wages paid to an employee and then roughly 3% on any amounts over $100,000 of wages paid to an employee.
Paying out $100,000 of business profit to each shareholder employee as wages bumps the employee tax expense of the corporation and shareholder by somewhere between $3,000 and $15,000 a year (depending on how much other earned income the shareholder-employees have).
If Acme operates as an S corporation, however, only those amounts the corporation pays to shareholder employees as wages are subject to employee taxes. Amounts the corporation pays out of profits to shareholders as distributions of profit are not subject to employment taxes.
Final Thoughts on C Corporation Versus S Corporation Decisions
Before I wrap up this discussion, let me share a handful of miscellaneous points related to the C corporation versus S corporation decision:
1. You can change from a C corporation to an S corporation by filing a 2553 form with the Internal Revenue Service and (when necessary) by filing an equivalent S election form with the state revenue agency.
2. If you make an election to have a corporation treated as an S election at a point other than when the corporation comes into existence—in other words, other than at the incorporation date—you need to be careful for a couple of reasons. First, an S corporation may pay C corporation taxes on income that it earned and on gains that occurred if that income was earned or those gains stem from the part of its corporate life when it was a C corporation. These taxes are typically called “built-in gain” taxes. You should consult with a local, knowledgeable tax practitioner, therefore, if you’re converting a C corporation to an S corporation at some point other than the incorporation date.
3. Here’s another point related to making an S election at a point other than on the incorporation date. If the corporation has earnings and profits it has retained from the period of time during which the corporation operated as a C corporation, those retained earnings need to analyzed by a knowledgeable tax practitioner for a couple of reasons. First, if they’re paid out to the shareholders, the shareholders will owe dividend taxes on them—so any payout should be done thoughtfully. Second, the retained earnings and profits can create terminate the S corporation status if the corporation enjoys passive investment income (such as from real estate rental income) of more than 25% of its gross receipts for three years in a row.
4. You can convert a subchapter S corporation to a C corporation in either of two ways. Perhaps the easiest conversion occurs when you do something that an S corporation is ineligible to do. For example, S corporations can’t have C corporations, partnerships, or foreign taxpayers as shareholders. Accordingly, if you sell one share to a C corporation, partnership or foreign shareholder, that should terminate the S corporation status. Another way to terminate a subchapter S election is to have the shareholders and the corporation both make formal statements revoking the election. Revocation statements need to follow specific guidelines (which are provided in Treasury Reg. Sec. 1.1362-2 and Treasury Reg. Sec 1.1362-6), so you may want to enlist the services of a knowledgeable tax practitioner. Note that if a corporation does revoke an S election, the corporation must wait five years before making another S election. You can’t, as a practical matter, flip-flop between S corporation and C corporation status.