Incorporating your business is a big step, but with careful planning, it can go smoothly. One of the first decisions to be made is how your corporation will be structured. The two options are C corporation and S corporation. Each type is named after the subchapter of the Internal Revenue Code that defines it. Although there are some similarities between the two structures, there are several important differences that you should understand before making a decision and proceeding.
Shareholders and Ownership
A C corporation can be owned by a mix of other corporations, LLCs and individuals, including foreign investors. S corporations, on the other hand, can only be owned by individuals, and these individuals must be citizens of the United States or resident aliens. S corporations are also limited to 100 shareholders, whereas the number of investors in a C corporation is generally not limited by law. This sometimes makes the S corporation structure better suited to smaller companies than larger companies. If you hope to eventually open up your corporation for public trading or think the company would significantly benefit from foreign investors or crowdfunding, an S corporation may not be the best choice in your case.
Another limitation that S corporations contend with has to do with their allowable stock classes. In addition to being limited in number, an S corporation’s stocks must be of equal value across the board. On the other hand, a C corporation’s stocks can have different classifications, for example, being weighted heavier for initial investors and others. This variety of stock classes can give more voting power or different profit levels to their holders. Therefore, establishing your business as a C corporation can give you more flexibility when trying to attract investors.
Taxes are a major concern in every aspect of business planning, and this is no less the case when a company is incorporating. For a small business looking to incorporate, the tax details are sometimes the deciding factor when choosing between the two types of corporations. A C corporation is considered to be subject to double tax liability because its income is taxed at the corporate level and then each shareholder’s dividends are taxed again as personal income. With an S corporation, on the other hand, there is no corporate income tax. Instead, the business is considered a “pass-through” entity, much like an LLC, where income is reported to the IRS but not taxed. Funds pass through the company and are reported as profits or losses on the individual owners’ tax returns. Particularly in the case of small businesses, this may make better financial sense for the shareholders.
Making a Decision
There are many benefits to incorporating a business, including limiting your personal liability for business debts and paying income tax on a salary and/or dividends instead of being liable for self-employment tax. Corporations also have the benefit of perpetual existence and may have broader access to capital, including alternative forms of funding, than other business structures. In the view of some lending companies, corporations are more desirable to work with than other types of businesses, such as partnerships or sole proprietorships.
If your small business is on the verge of incorporating, it might be worth considering registering as an S corporation for the tax benefits. On the other hand, if you anticipate growth and want to go public at some point in the future, a C corporation might be a better fit. The rules for incorporation are different in each state, and you have a limited time after incorporating to register as an S corporation if that is what your shareholders agree to do. Your attorney or CPA can help you find the best solution for your circumstances and can assist you in planning for future growth.
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