C corp vs S corp: Differences, benefits, and how to set them up

When the time comes to choose a corporate structure for your new business, it’s crucial to do your research. This decision impacts everything from tax obligations and liability protection to the ability to raise capital. You’ve probably heard of C corporations (C corps) and S corporations (S corps) as they’re two popular choices, each with their own pros and cons. In this article, we’ll break down the difference between S corp and C corp, talk about the benefits and drawbacks of each, discuss how to start a C corp or S corp, and explore how you can decide which option is best for your business structure. 

C corporation vs. S corporation defined

Before going any further, let’s clarify what C corporations and S corporations are.

What is a C corporation?

A C corp is a legal business entity that offers limited liability protection for its shareholders. This means that the shareholders' personal assets are generally protected from business debts and liabilities. C corps can have an unlimited number of shareholders, allowing for extensive investment opportunities.

What is an S corporation?

Like a C corporation, an S corporation is a legal business entity that provides limited liability protection to its shareholders. However, S corps have restrictions on the number of shareholders and the type of stock they can issue. S corps also offer pass-through taxation, where profits and losses are reported on shareholders' personal tax returns, avoiding double taxation. 

S corp vs. C corp: Main similarities

C corps and S corps are both legal business entities and share several similarities: 

Limited liability protection

Both C corps and S corps offer limited liability protection, which shields owners’ personal assets from business liabilities.

Corporate formalities

Both structures require that business owners adhere to corporate formalities, like holding annual meetings, maintaining records, and filing necessary paperwork.

Compliance requirements

Both S corps and C corps are required to comply with federal and state regulations, including corporate governance rules and tax obligations. Both business structures are required to pay payroll taxes on the salaries of their full-time employees. 

Separate legal entities

C corps and S corps are both recognized as individual legal entities, which means they can enter into contracts, be sued, and own property in their own names.

Key differences between S corp and C corp

While they share similarities, there are important differences between S corps and C corps:

Initial formation

Both C corps and S corps are formed by filing Articles of Incorporation, but S corps must also file Form 2553 to elect their S corporation status after formation.

Taxation

S corporations benefit from something called “pass-through taxation,” which means they don’t pay corporate taxes on their profits. Instead, the company’s individual shareholders pay themselves dividends and report it on their personal income taxes. C corporations, on the other hand, pay corporate taxes on their profits, and shareholders pay taxes on dividends, often referred to as “double taxation.” 

Corporate ownership

C corps and S corps differ in their corporate ownership. C corps can have an unlimited number of shareholders, including foreign investors, while S corps are limited to 100 shareholders, all of whom must be U.S. citizens or residents.

Shareholder agreements and stock issuance

C corporations have the flexibility to issue multiple classes of stock, including common and preferred stock. S corporations, on the other hand, can only issue one class of stock, which may limit investor options.

C corp pros and cons

When deciding between business structures, it’s essential to weigh the pros and cons of C corporations and S corporations.

C corp benefits

1. Unlimited shareholders: C corps can have an unlimited number of shareholders, making them ideal for larger businesses seeking significant capital investments.

2. Foreign investor friendly: There are no restrictions on the origin of shareholders, allowing foreign investors to hold shares in the company.

3. Limited liability protection: C corporations provide limited liability, safeguarding personal assets from business debts and liabilities.

4. Multiple classes of stock: The ability to issue multiple classes of stock attracts a diverse range of investors, facilitating capital growth and investment opportunities.

C corp drawbacks

1. Double taxation: One significant disadvantage is double taxation. Corporate profits are taxed at both the corporate level and again at the individual level when dividends are distributed.

2. Higher administrative costs: C corps face higher administrative costs due to more complex regulations and requirements, which can strain financial resources

3. More complex setup and maintenance: Establishing and maintaining a C corp requires extensive paperwork and compliance, which can be an added burden for business owners

S corp pros and cons

S corporations also have their own unique advantages and disadvantages.

S corp benefits

1. Pass-through taxation: S corps offer pass-through taxation, meaning profits are taxed only at the individual level, which can lead to tax savings.

2. Limited liability protection: Like C corporations, S corps also provide limited liability, protecting personal assets from business-related risks.

3. Avoids corporate-level taxation: S corporations eliminate double taxation, making them a tax-efficient choice for many small businesses.

S corp drawbacks

1. Shareholder restrictions: S corporations are limited to 100 shareholders, all of whom must be U.S. citizens, which can restrict growth opportunities.

2. One class of stock limitation: S corps can only issue one class of stock, limiting flexibility in ownership and potential investor appeal.

3. More stringent qualification requirements: To maintain S corp status, companies must meet specific IRS guidelines, which can complicate compliance.

C corp or S corp: Which is best for you? 

Choosing between a C corporation and an S corporation depends on your company's size, growth plans, and investment needs. Consider your long-term goals, how many people you have on your payroll, and what kind of investors you want to attract. Every business is unique, so there is no one-size-fits-all answer.

Alternatives to consider: Other types of corporations

When exploring business structures, consider alternatives to C corporations and S corporations. Here are some popular options that may suit your needs:

Limited liability companies (LLCs)

Limited Liability Companies (LLCs) are an excellent choice for small businesses and sole proprietorships. They offer the advantages of limited liability protection while benefiting from pass-through taxation. This structure safeguards personal assets and simplifies tax obligations, making LLCs a favored option for entrepreneurs.

Benefit corporations (B-corps)

Benefit Corporations (B-Corps) are for-profit companies that emphasize social and environmental responsibility alongside shareholder profits. If your business wants to make a positive impact while generating revenue, establishing a B-Corp can enhance your credibility and attract socially conscious consumers.

Nonprofit corporations

Nonprofit Corporations are specifically designed for charitable purposes. These entities can apply for tax-exempt status, allowing them to operate without paying federal income tax. If your mission aligns with charitable goals, a nonprofit structure may be the ideal choice.

Partnerships

Partnerships are suitable for two or more individuals looking to co-own a business. But partnerships do not provide liability protection. Each partner is personally liable for business debts, which can pose risks. This business structure allows for shared decision-making and resources, making it a popular option for business owners who want to pool their expertise and capital.

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Frequently asked questions

Can a C corp transition to an S corp?

Yes, a C corporation can transition to an S corporation by filing Form 2553 with the IRS, provided it meets all the eligibility requirements of an S corporation. This transition allows businesses to benefit from pass-through taxation, reducing the risk of double taxation on corporate earnings.

Should my startup be an S corp or a C corp?

The choice between an S corporation and a C corporation depends on your startup's funding needs and long-term goals. Startups seeking venture capital funding often prefer the C corporation structure, as it allows for multiple classes of stock and easier investment opportunities. On the other hand, if you want to avoid double taxation and want a simpler tax structure, an S corporation may be the better option for your business.

How do you tell if a corporation is S or C?

To determine whether a corporation is an S corporation or a C corporation, check its tax filings or IRS documentation. If the corporation has elected to be taxed under Subchapter S, it is classified as an S corporation. If not, the corporation is considered a C corporation.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.