Karla Dennis, EA, MST & CEO of The Award Winning Tax Accounting Firm Karla Dennis and Associates Inc. — Specializing In Tax Planning
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Are you a new small-business owner who wants clarity on the main difference between an S corporation and a C corporation? One of the first things you will have to consider as a business owner is your business entity. As a tax professional, I get asked all the time by entrepreneurs how these two business statuses differ. It is actually one of the most common (and most important) questions I am asked because it is so critical to understand how you are taxed as a business owner — so you can avoid being overtaxed.
Here is what you need to know from a tax perspective.
First Things First
Both S-corps and C-corps start out equal, as corporations. Your business is a legal entity, which is born by filing your articles of incorporation under the secretary of state where your business will receive a corporate number, solidifying your business as a legal entity. By doing this, you are making your business separate and distinct from its owners.
The Main Differences With An S-Corp
1. To be a legal S-corp, you must file Form 2553, which will enable the IRS to link your personal income tax return to the corporate return. By doing this, income or loss will flow to your personal income tax return.
2. Come each March 15, as an S-corp, you will use the Schedule K-1 form. This form is individually prepared by shareholders and breaks down the shareholders’ individual income, losses and dividends. This means that the income they receive is going to get taxed at personal income tax rates. This is the main difference between an S-corp and a C-corp — the individual income tax rates.
3. When issuing stock, an S-corp is considered “closely held,” meaning that typically one or two people make the company’s decisions. If you are considering making your business public one day, you might not want to elect S-corp status because once you make that selection and file the forms above, you are locked into that decision for at least five years.
4. Another important difference with an S-corp relates to the way losses flow over to your individual return. If you have a loss sitting in your S-corp, it flows to your individual return. If you also have W2 income on your individual return, that loss coming from your business can help offset your W2 income. You can’t do that in a C-corp.
The Main Differences With A C-Corp
1. As of this writing, the corporate income tax rate is 21% meaning your net business income will be taxed at that rate and not at an individual tax rate, such as with S-corps and sole proprietorships. That’s big because over the years, the corporate tax rate can change. Before the Tax Cuts and Jobs Act changed the rate to the current 21% starting in 2018, the top rate in recent years had been much higher.
2. Another thing to take into consideration with C-corps is shareholders. If you are considering taking your company shares public like Google or Apple, you will have to launch an initial public offering (IPO) allowing you to raise capital from public investors by going through this five-step process.
3. C-corps also allow for a lot more benefits. Take healthcare deductions, for example. With a C-corp, health insurance costs are deducted at the company level, making health insurance tax-free for you, the owner. That’s a big deal because in an S-corp, health insurance costs cannot be deducted by the company but rather are passed down to you as the shareholder and get reported on Schedule A of your itemized deductions.
4. In a C-corp, you also have different compensation plans that wouldn’t be available as an S-corp for tax liability purposes. As an S-corp, you have to report your fair share of income on your personal income tax return whether or not you actually take the income. This means that you, as an owner, pay taxes based on your distributive share of ownership. If you don’t take the income, this creates what we call “phantom income.” As a C-corp, business owners receive a salary, which varies depending on the industry, company size, location and profitability.
As you can see, there are some major differences between an S-corp and a C-corp, which are all very important to consider when making your decision. As a business owner, it’s best to assess where you are right now and where you want to go with your business. Then speak to a licensed tax professional who can advise you on how to go about reaching those goals from a tax perspective.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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