When starting a business, the first question many people ask themselves (or their attorney) is: “What structure should I use?” There are three primary options people choose from when organizing a business: corporation, limited liability company, and partnership. This choice is important for many reasons, as it impacts the areas of tax planning, corporate governance, and operational flexibility, among others.
One of the most common entity structures is the corporation. It is also the case that the corporation is of the more formal entity structures – governed strictly by both statute and caselaw. As corporations are more strictly regulated (compared to other business entities), there are a few more items to consider when electing to form a business as a corporation. I consider one of the most common questions asked by those forming a corporation below: “C corporation or S corporation? Which is best for me?”
Similarities: Prior to going into the key differences between a C corporation and S corporation, I want to be clear to point out important similarities. Regardless of whether you elect S corporation status (generally, one does not elect C corporation status, as that is the default status that corporations are formed in), there will be several items that hold true regardless of corporation status. This makes sense because the impact of being a C corporation or S corporation is largely felt in the tax and accounting side of a business, and therefore many of the structural and procedural aspects of a corporation remain the same – regardless of status.
- Incorporation: Each state has its separate and distinct rules related to the incorporation of a business. Typically, these requirements do not change or differ based upon the corporation being a C corporation or an S corporation.
- Statutory Compliance: As mentioned above, each state promulgates both mandatory and voluntary statutes with respect to the operations of a corporation in its state. By and large, these statutes do not distinguish between C corporation or S corporation status – rather they are blanket regulations that cover any form of corporation.
- Governance: Regardless of C corporation or S corporation status, a corporation will continue to be governed by a Board of Directors and suite of officers (such as the CEO, CFO, etc.). The governance of a corporation is dictated by state statute and, as discussed above, state statutes typically do not distinguish with regard to C corporation or S corporation status.
- Protection of Shareholders: The election to have your corporation taxed as an S corporation will not impact the limited liability protections of shareholders. Stated otherwise, the limited liability of shareholders of a corporation is no different if the shareholders are those of a C corporation or S corporation.
Differences: There many differences between C corporations and S corporations. The two main differences relate to taxation and ownership.
- Taxation: C corporations are taxed as separate entities – apart from their shareholders. Meaning, that a C corporation pays taxes on its income at the corporate level – not at the individual shareholder level. Additionally, if any income from a C corporation is distributed to its shareholders in the form of dividends, those dividends are subject to tax on the individual level (paid by the shareholders who receive such dividends). In contrast, S corporations are what are called “pass-through” entities. This means that there is no tax paid by the corporation on income earned at the corporate level, rather all of the income is “passed-through” to the individual shareholders and each shareholder pays tax on the income at such shareholder’s individual tax rate. The key difference here is that an S corporation only has one level of taxation – at the shareholder level. As seen above, a C corporation has two levels of taxation – one at the corporate level when the income is earned and a one at the shareholder level when dividends are paid. The lack of “double taxation” in the S corporation structure is one of the most common reasons that many entities elect S corporation status.
a. S corporations (i) may not have more than 100 shareholders; and (ii) may not have any shareholder who/that is a limited liability company, trust, partnership, corporation (with limited exceptions), or non-United States citizens. C corporations do not have any of these restrictions.
b. Unlike the multi-class structure often seen in C corporations, S corporations are only allowed to have one class of stock.
The taxation and ownership considerations summarized above hold different weight depending on the goals and objectives of your organization. As you can imagine, some corporations would benefit greatly from the pass-through nature of the S corporation, while others (such as corporations that do not routinely pay dividends) would not realize the same benefit. Additionally, those entities seeking to raise capital through equity issuances may have a difficult time doing so as an S corporation due to the shareholder restrictions mentioned above. All of these items are considerations that one should walk through with their attorney, accountant, etc., when forming a corporation.