Double taxation refers to how income earned by C corps is taxed twice: once when the corporation earns income, and again when it distributes dividends to its owners (who then pay taxes on those dividends).
S corps avoid double taxation by passing their income through to their shareholders directly. S corps don’t technically pay taxes—instead, their owners do on their personal income tax return.
S corp status could save you money on your taxes, but it also comes with restrictions on the make up and number of shareholders. S corps can’t have more than 100 shareholders, they all have to be U.S. citizens, and they can only own one class of stock, for example.
The difference between C corps and S corps
What is a C corporation?
C corporations are the default type of corporation—all corporations (even S corps) start as one. If you run an incorporated business in the United States and you haven’t filed for S corp or LLC (limited liability company) status, you’re automatically considered a C corporation by the IRS.
People incorporate for lots of reasons—to formalize their business, open it up to new investment, lower their tax bill, etc. But the main reason people do it is because it gives their business a superpower called limited liability protection.
Limited liability protection (or just liability protection) gives the owners of a corporation protection from that corporation’s creditors. This means that if the corporation you own ever goes bankrupt, your creditors can come after the corporation’s assets, but not your personal assets.
This is because unlike partnerships and sole proprietorships, the law considers corporations to be a separate legal entity (or a separate “person”) from their owners.
How do I incorporate a business?
To create a corporation, you have to pick a state to incorporate in, pick a name for the company, file articles of incorporation (also called certificate of incorporation) with your state, and get it approved.
Corporations have a board of directors that makes decisions about the direction of the company, so you’ll have to elect one of those. They also have shareholders, who the board will have to distribute shares (small pieces of your company) to. And they have officers who manage the company day to day (like the CEO and the CFO), so the board will have to appoint those too.
You’ll also have to adopt a set of bylaws, which determine how your corporation will function. And you’ll probably also have to secure a bunch of licenses and permits, set up a separate business bank account, get an Employer Identification Number (EIN) from the IRS, and sign up for payroll tax payments with the IRS if you have any employees.
You can read more about all of this in our guide to incorporating a business.
How are C corporations taxed?
The IRS considers the income and losses of C corporations separate from the income and losses reported on your personal tax return. That means that in addition to filing a personal tax return (Form 1040) you’ll also have to file a separate corporate tax return (Form 1120).
It also means that if your corporation earns any income, it will effectively be taxed twice: once when its reported on your corporate tax return, and again when you report dividends (profits distributed to corporation owners) on your personal tax return.
What are the benefits of C corporation status?
It formalizes the business
One of the biggest decisions business owners have to make when incorporating is figuring out an equity split—or, how much of the business each owner will get to keep. Do you feel like you’re doing the lion’s share of the work in your business? Incorporation gives you a chance to bring that up with your co-founders and come up with an equity split that reflects that.
It might lower your tax bill compared to a sole proprietorship
Corporations pay tax at a special corporate income tax rate that is different from (and often lower than) the individual tax rates you pay when you’re a sole proprietor. This is especially true under the Tax Cuts and Jobs Act, which reduced the C corp tax rate to a flat 21% of all business income.
It opens the business to investment
Incorporating makes it a lot easier for others to invest in your business, mainly because it lets you issue stock (i.e. shares in the company) and have shareholders. Investors are a lot more willing to give you money if they get a stock certificate in exchange for it, rather than a simple handshake or IOU.
It makes you look official
Incorporating also signals to investors, employees and the public that your business is legit and that it’s serious about growing. Wouldn’t you rather do business and sign a contract with a corporation than with Ricky Bobby with a hotmail address?
What are the drawbacks to C corporation status?
It’s expensive to incorporate
Compared to other business structures like sole proprietorships (which you start automatically just by doing business) and partnerships (which you can form with a handshake agreement), it’s expensive to start and run a C corporation. Depending on how and where you incorporate, the whole process could cost you thousands of dollars.
It involves lots of regulation and paperwork
C corps have to follow many regulations at the federal, state, and local level. If you incorporate as one, you’ll probably have to do a lot more paperwork than you would operating a partnership or sole proprietorship. Remember that when you incorporate, that’s a whole new set of financial and tax records that you have to keep track of, which could suck up a lot of your time.
It might cost you more in taxes
Incorporation can actually leave some business owners spending more on business taxes. Corporations don’t have access to the same credits that individuals have on their personal tax return, and if you incorporate, you can’t reduce your personal income by any losses you sustain—you’ll have to carry them forward into another tax year.
Double taxation
Because they’re taxed separately from their owners, C corps also pay taxes twice: once at the corporate level, and again at the personal level when it pays out dividends to its owners. If you own a C corp and intend on distributing dividends, you might be able to cut down your tax bill by filing for S corporation status.
What is an S corporation?
S corporation status is a special tax designation granted by the IRS that lets corporations pass their corporate income, credits and deductions through to their shareholders.
Generally speaking, S corporations don’t pay federal income taxes. Instead, the company’s individual shareholders split up the income (or losses) amongst each other and report it on their own personal tax returns, letting them avoid double taxation. With a combination of liability protection from incorporating and avoiding double taxation, the S corporation tax status is appealing for small business owners.
Keep in mind that “S corporation” is a tax designation, not a business entity type. You can’t ‘incorporate’ as an S corporation, but you’re recognized as an S corporation for tax purposes. To become one, you have to apply to the IRS.
How do I apply for S corporation status?
Before you apply for S corp status, you have to be a C corp first, which means you’ll have to incorporate your business.
Once you’ve done that, you’ll have to make sure you qualify for S corporation status by satisfying the following requirements:
- It must be based and operating in the United States.
- It can only have “allowable” shareholders—i.e. none of your shareholders can be partnerships, other corporations, or non-resident shareholders.
- It cannot have more than 100 shareholders total.
- It can only have one class of stock—for example, it can’t have a two-tiered common and preferred stock system.
- It can’t be an insurance company, bank or a domestic international sales corporation.
- All of the company’s shareholders must unanimously consent to S corporation status.
Finally, you’ll have to file Form 2553, Election by a Small Business Corporation, signed by all of your company’s shareholders.
For more, consult our in-depth guide to applying for S corporation status.
What are the benefits of S corporation status?
You avoid double taxation
As we mentioned above, C corporation income is taxed at the corporate and personal level, while S corporation income is only taxed at the personal level. If your company is making a profit and you want to take some of that money out of the company, it’s generally cheaper to do so as an S corp than a C corp. But note that in some cases, the personal income tax rate paid by S corp shareholders will be higher than the corporate income tax rate.
You may reduce your self-employment tax bill
Unlike owners of sole proprietorships, partnerships and LLCs, S corp owners only pay self-employment taxes on their wages rather than their entire share of the company’s taxable income. All other income is paid to shareholders in the form of “distributions” that are not subject to self-employment tax, which makes S corporation status very attractive to many small businesses.
For example, let’s say you’re the founder and CEO of Fun Toyz Inc., an S corporation which you have a 40% ownership stake in.
You earned a $40,000 salary this year from XYZ Inc., and the company also earned a net profit of $30,000 that year, which you’re entitled to 40% of—or $12,000.
Because Fun Toyz Inc. is an S corp, you’ll only have to pay self-employment tax on the $40,000 salary, and not on the $12,000 distribution.
You may wonder why S corp owners don’t just take a salary of $0 to avoid self-employment taxes altogether.
The catch here is that if you’re a shareholder and an employee of the company, which most small business shareholders are, you must pay yourself a “reasonable salary” before paying yourself a tax-free distribution.
What exactly is a reasonable salary? The IRS has no hard and fast rules for this one. But you should try to base it on position, experience, business size and what a comparable position at another company in your industry would earn. Whatever salary you decide on, be sure you’re able to justify it to the IRS if you ever get audited.
Further reading: S Corp Taxes: A Simple Guide
What are the drawbacks of S corporation status?
Strict requirements
If your company fails to meet any of the IRS’s requirements for S corporation status at any point, the IRS can revoke it immediately and tax it as a C corporation instead, which could create huge problems around tax time. S corporations are also required to file annual reports with their secretary of state which increases the admin work you’ll be doing every year.
Closer tax scrutiny
The IRS keeps a close eye on whether the “reasonable” salaries corporate officers are paying themselves are, indeed, reasonable.
If the IRS suspects a shareholder has underpaid wages in order to decrease their tax burden, they may reclassify some distributions as wages, which could increase the shareholder’s tax liability significantly.
The rules vary by state
While tax advantages make the S corporation an attractive status, S corps aren’t treated equally by each state government. For instance, some states choose to follow the federal tax requirements for S corps, while others ignore the S corporation status and tax the company as a C corporation.
Chat with a CPA or tax professional to make sure you’re aware of your state’s tax laws and S corporation rules.
So which status is right for me: C corp or S corp?
Generally speaking, you should stick with C corporation status if:
- You’re a new and growing business, and intend to reinvest profits back into the business
- You’re raising money from investors (who are much less likely to invest in a pass-through entity)
- Any of your owners aren’t U.S.-based
On the other hand, you should consider applying for S corporation designation if:
- You (or any other owner) want to take profits out of the company in the form of distributions
- You’re a domestic corporation
- You don’t plan on having more than 100 shareholders
- You intend on paying yourself a “reasonable salary,” as defined by the IRS
How Bench can help
Making a change like incorporating can be intimidating. But when you talk it through with a tax professional, you can make a decision confidently knowing how it will affect your operations.
With Bench, you get access to unlimited, on-demand consultations with our tax team. Whether it’s a big picture change like your business type or a quick chat about year end tax moves, you’ll have a helping hand in your corner ensuring you’re making the best choices for your business. Get started today with our all-in-one bookkeeping, tax filing, and tax advisory services.
