What is a Corporation?
A corporation is a business structure treated as a separate legal entity from its owners—also known as shareholders—and guided by a board of directors. There are two types of corporation designations to consider for tax purposes: C corporations (C-Corps) and S corporations (S-Corps). C-Corps are the default structure, but corporations may elect to be treated as S-Corps if they fit certain criteria.
As separate legal entities, both C corps and S corps provide limited liability protection to their shareholders. This means that shareholders’ personal assets are protected from being used to cover business debts and other liabilities.
Corporations that elect C-Corp and S-Corp status are also governed in the same way. The owners of a corporation are shareholders. These shareholders elect a board of directors, who are responsible for making all major business decisions. The board of directors then elects officers (e.g. CEO) to handle the business’s day-to-day affairs.
All corporations are responsible for maintaining corporate documents and compliance in order to keep the company in good standing. This means passing bylaws, holding regular meetings and keeping minutes, and keeping track of all corporate actions.
Double Taxation vs. Pass-Through Taxation
The main difference between a C corp and an S corp is how they are taxed. As traditional corporations, C corps are taxed as separate entities from their owners. This means that business profits are reported separately from shareholder profits and subject to the current corporate tax rate of 21%. This tax is applied to all profits within the business.
Once a portion of these profits is distributed to shareholders, in the form of dividends, each shareholder must report this income on their personal tax return, where it is then taxed at their personal rate. This is referred to as double taxation of dividends since the same profit is taxed first at the corporate rate and later at the personal rate.
Unlike C-Corps, S-Corps are considered pass-through entities for tax purposes, just like LLCs or general partnerships. As such, S-Corps do not pay taxes at the corporate level, and all profits pass through to shareholders to be reported on their personal returns.
Another important distinction between C-Corps and S-Corps is who can form and own each type of corporation. C-Corps do not place limitations on who can become a shareholder. There is no maximum number of owners, and shareholders do not need to be U.S. citizens or residents.
S-Corps, on the other hand, impose a limit of 100 shareholders and restrict ownership to U.S. citizens or residents. Unlike C-Corps, S-Corps do not allow other business entities, such as corporations, LLCs, or partnerships, to become shareholders.
C-Corps also offer more flexibility when it comes to shareholder rights. In a C-Corp, owners can create different classes of shareholders with varying rights within the company. These classes may affect how dividends are distributed, how capital is divided at dissolution, or how each shareholder votes.
S-Corps do not allow for this. There can only be one class of shares, typically referred to as ordinary shares, within an S-Corp.
C-Corps benefit from being able to deduct fringe benefits such as health, life, and disability insurance from their taxable income. These benefits are not taxable to employees or shareholders.
For tax purposes, the IRS classifies an S-Corp the way it does a partnership. As such, any employee or shareholder who owns more than 2% stock in the company is considered a partner and cannot deduct fringe benefits from their income at tax time.
How to Elect to Become an S-Corp
If your corporation meets all the criteria for being an S-Corp and you’d like to elect this status, you can do so by filing IRS 2553. You will need to include the following information:
- Company name and address
- Employer Identification Number (EIN)
- State and date of incorporation
- The effective date of S-Corp status
- Shareholder information
- Tax year information
This form must be filed no more than two months and fifteen days after the beginning of the corporate tax year.
Whether your business can benefit more from C-Corp or S-Corp status depends on a number of factors. The type of corporation you form will determine, at least in part, how your business is run, who can become a shareholder, and—perhaps most importantly—how your corporation is taxed. Because each situation is unique, speaking with an attorney or tax professional can help you make the most informed decision on this matter.