S Corporations Versus C Corporations, Term Paper Example

A corporation is a business legal structure that is entitled to limited liability. Whether it is a traditional C corporation or an S corporation, a corporation is a separate legal entity that is owned by shareholders and ruled by a board of directors who elect officers to manage daily activities (Wood, 2012).  Both S corporations and C corporations have their advantages and disadvantages.  Deciding on whether to file as an S corporation or a C corporation is dependent on the type of business, the situation of the business and its owner(s), and the ultimate goals for the business.  Filing for either an S corporation or a C corporation is a complicated process, and an accountant or an attorney should be consulted before a business decides on the type of legal structure.

C Corporations

The traditional term “corporation” is usually identified with C corporations.  All corporations are classified as C corporations by default, unless they specifically file for S status (Wood, 2012).  Even though it can be complicated, a corporation may be taxed as a C corporation for many years and then change to the status of an S corporation.

C corporations have many advantages. C corporations are ideal for organizations with more than 100 shareholders, or if the organization plans to conduct business on an international level.  If a business expects to use outside capital, filing as a C corporation is a good option to consider. Because C corporations are highly recognizable by the public, it is easier for them to obtain business capital and loans from banks than with other legal structure.  (Sullivan, 2000, p 33). According to the Internal Revenue Service [IRS], prospective shareholders are able to exchange money, property, or both for the corporation’s capital stock while in the process of forming a C corporation (2015a).  Even though C corporations have to pay double taxes, the tax breaks granted to them are substantial. C corporations can usually claim the same deductions as sole proprietorships for taxable income. They are recognized as a separate taxpaying entity when it comes to federal income taxes.  In addition, profits may be divided among shareholders and the corporation; this process reduces taxes by taking advantage of lower tax rates.  The IRS is generous to C corporations when it comes to taking special tax deductions.  A C corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders (IRS, 2015a).  C corporations enjoy favorable tax breaks for employee fringe benefits including medical, disability, and life insurance plans.  In addition, 70% of any dividends received by the corporation from stock investments are deductible, unless the stock is purchased with borrowed money (Sullivan, 200, pp. 33,34).  Another advantage of a C corporation is that the business does not dissolve if a shareholder or owner passes away or if there is a change in ownership.

There are however, many disadvantages to C corporations.  They have to pay a double tax; because the profit of a C corporation is taxed to the business when earned, and then is taxed to the shareholders when distributed as dividends.  Since C corporations do not receive tax deductions when they distribute dividends to shareholders, and as a result, shareholders of C corporations cannot deduct any financial losses (IRS, 2015a).  C corporations are more expensive and complex to set up than most other legal structures , so the availability of outside capital is highly beneficial (Sullivan, 2000, pp. 34).

Completing tax returns is a complicated process for C corporations and usually requires the assistance of an accountant.  Not only do C corporations have recurring annual corporate fees, their tax rates are higher than individual rates for profits greater than $75,000. In addition, 28% of accumulated earnings are taxed on profits in excess of $250,000 (Sullivan, 2000, pp. 34). According to the IRS, C corporations “that have assets of $10 million or more and file at least 250 returns annually are required to electronically file their Forms 1120 and 1120S for tax years ending on or after December 31, 2007” (2015a). C corporations are responsible for filing income taxes, estimated taxes, employment taxes, and, and excise taxes.  Employment taxes include: Social Security, Medicare tax, income tax withholding, and Federal Unemployment (FUTA) tax.

S-Corporation

The IRS states that S corporations are “corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes” (2015b).  The legal status of S corporations is favorable to small businesses and is a popular form of incorporation in the start-up years of a business (Sullivan, 2000, p. 34, 35).

S corporations have many advantages of C corporations.  Just like with C corporations, the legal status of S corporation allows the shareholders to enjoy personal limited liability and does not dissolve if one of the shareholders or owners passes away or leaves the company. However, unlike C corporations, S corporations are not penalized with the double taxation.  Shareholders of S corporations report the “flow-through” of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.  This allows S corporations to avoid double taxation on the corporate income (IRS, 2015b).  In addition, “wholly owned subsidiaries are permitted” and any losses are passed through to the shareholders (Sullivan, 2000, p. 35).  S corporations are ideal for a business in its first few years so any losses can be passed through to the owners as a tax relief.  C corporations are not allowed to claim losses on their tax return (Sullivan, 2000, p. 37).

The disadvantages for S corporations are few.  Even though they do not receive as many tax breaks as C corporations, they do not have nearly as many penalties.  S corporations are responsible for tax on certain built-in gains and passive income at the entity level (IRS, 2015b).

It can be a complicated process for a business to become an S corporation, and the assistance of an accountant or tax attorney is highly recommended.  In order to become an S corporation, the business must submit Form 2553 Election by a Small Business Corporation, and be signed by all of its shareholders (IRS, 2015b).  The IRS (2015b) states that in order to qualify for S corporation status, the business must meet a series of requirements.  The business must be domestic and have only one class of stock.  The criteria for its shareholders is also very strict.  Shareholders may be individuals, and affiliated with certain trusts and estates.  Shareholders of S corporations cannot be international, and are restricted to United States citizens and resident aliens.  Shareholders may not be partnerships, corporations, or non-resident alien shareholders.  S corporations are not allowed to have more than 100 shareholders, and they cannot be an “ineligible corporation.” Examples of eligible corporation include “certain financial institutions, insurance companies, and domestic international sales corporations” (IRS, 2015b). If there are multiple classes of stock, only differences in voting rights are allowed.  “For most small businesses, these criteria are easy to meet” (Wood, 2012).  S corporations are liable for income tax, estimated tax, employment tax, and excise tax (IRS, 2015b).

What to Choose?

Whether or not a business chooses an S corporation over a C corporation as its legal structure is dependent on many factors.  The type of business, its size and number of employees, its shareholder(s), the amount of shareholders, and its age must all be taken into consideration. S corporations tend to be better for smaller businesses, because they are not responsible for double taxation and if they incur losses, the shareholder(s) are able to claim them personally (Wood, 2012). But while it may seem that S corporations have more advantages than disadvantages than C corporations, it is prudent to remember that the reason that C corporations face such high tax penalties is largely due to their ability to reap such high profits.  If a business plans to operate on a global level or plans to have more than 100 shareholders, it is more beneficial to become a C corporation.  The process can become complicated and it is recommended that businesses consult with an accountant or attorney before determining their legal status.

Filing for the legal status of an S corporation is especially complicated.  While it may seem like an easy transition for LLC shareholders who are more comfortable with a corporate format system, they must meet a strict set of criteria before they can qualify.  Even though a corporation may be taxed as a C corporation for many years and then change to S status, converting to an S corporation is especially hard for an existing C corporation.  An S corporation can face corporate tax if it was previously a C corporation and elected S status within the last 10 years.  Alternatively, by filing the S election upon initial formation, it will never be a C corporation, so does not need to worry about the built in gain tax on conversion from a C corporation to an S corporation.  However, there is no law preventing the business from converting from an S corporation to C corporation, if the business changes its goals (Wood, 2012).  According to Wood (2012), businesses can save themselves a lot of trouble if they start out as an S corporation.  They just have to make sure that they file the “S election” within 75 days of forming their corporation.

For any business that wants to expands their horizons and options for profit, obtaining a corporate legal status is ideal.  Choosing between an S corporation or a C corporation is dependent on many factors.  It is important to work with a qualified accountant or attorney, because the results can be advantageous when a business chooses to file as the appropriate legal structure, but disastrous if a mistake is made.

References

Internal Revenue Service. (2015a, August 5).  C corporations.  Retrieved from https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Corporations

Internal Revenue Service. (2015b, August 5).  S corporations.  Retrieved from https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations

Sullivan, R. (2000). Getting started. The small business start-up guide (pp 22-52). Great Falls, VA: Information International

Wood, R.W., (2012, May 3). C or S corporation choice is critical for small business. Retrieved from: http://www.forbes.com/sites/robertwood/2012/05/03/c-or-s-corporation-choice-is-critical-for-small-business/