As we’ve previously discussed in these blog post, entity selection is a very important matter, one which requires a careful analysis of all relevant facts and circumstances. Choosing an entity that isn’t ideal for a situation can have negative financial consequences, so it’s imperative that the best entity be chosen. In this blog post, our New York City tax attorneys discuss corporations; specifically identifying and discussing the highlights and some of the key differences between a C corporation and a S corporation.
Among those without formal training, the term “corporation” is typically used very loosely to include practically any type of business entity with multiple members. Many laypeople would consider a partnership, limited liability company, or other small business entity to be corporations, even though none of these entities would be referred to as a corporation by a legal practitioner. In fact, among tax attorneys, CPAs and other specialists, the term corporation is seldom used by itself without further clarification. When used by a specialist, however, the term “corporation” usually refers to either one of these two business entities. As we will see, these two entities, though similar in some ways, have a number of significant differences which can impact their desirability in a given context. Let’s go over exactly what makes each of these entities unique and then provide some tips for making the proper selection.
In many ways, a C corporation can be thought of as the “default” corporation. A C corporation is the entities people conceive of when they hear the word “corporation.” When you form a corporation by filing articles of incorporation with a state government, you will create a C corporation unless you later specifically elect to have the corporation treated as an S corporation. As an entity, a C corporation offers certain advantages to business people who are seeking to further their business agenda. For one thing, a C corporation can have an unlimited number of shareholders; this differentiates a C corporation from an S corporation, and it allows the C corporation to expand its business more easily, as it can recruit any number of new investors.
The shareholders of a C corporation own a slice of the underlying business and also have liability protection. This means that the shareholders are not liable for debts incurred by the corporation. Shareholders of a C corporation receive dividends from corporate profits, which means that they receive a portion of the profits consistent with their ownership percentage. As we’ve discussed before, dividends are unique to a C corporation, as S corporations and other small business entities distribute income to shareholders but do not give “dividends” as such.
Arguably the most salient feature of C corporations is the way they are taxed. C corporations are subject to “double taxation,” which means that the income they generate is taxed once at the federal corporate tax rate, and then again when that income is sent to individual shareholders in the form of dividends. This double taxation of the C corporation is one of the main drawbacks of these entities and a big reason why some business people choose, instead, to create a S corporation.
The S Corporation
S corporations are quite literally “small business corporations” – that is, they are corporations which have elected to be taxed as partnerships and other small business entities. S corporations therefore have the benefit of pass-through taxation, which means that all of the income generated by the S corporation passes through directly to the individual shareholders and is reported on their individual returns. Hence, unlike C corporations, a S corporation isn’t subject to double taxation, and for this reason is the preferred choice for many business people. However, S corporations can issue only one class of stock, whereas C corporations can issue multiple classes of stock. This gives C corporations an advantage over S corporations, in this respect, as C corporations can offer investors different classes of stock depending on the circumstances.
S corporations can only have 100 shareholders; this makes intuitive sense, because an S corporation is a small business entity and so it makes logical sense that these corporations would have some type of ceiling on the number of possible shareholders. This shareholder ceiling should certainly be considered when a person decides to make their entity selection, because S corporations won’t be eligible to become publicly traded. Accordinglgy, if the growth of one’s business is in some way impacted by its size, then electing S corporation status may be inadvisable. Ultimately,then, it becomes clear that each of these entities has its own strategic advantages depending on the situation, so it’s up to business owners to make a thorough account of all pertinent facts and then make an informed choice. If owners want to take advantage of pass-through taxation, but can deal with the limitations of S corporations, then taking this route may be the best decision; if, however, owners want more room for expansion, but can handle the double taxation of C corporations, then the C corporation route might be better.
Memorizing the tax implications of C corporations and S corporations usually doesn’t earn a top spot on most people’s favorite activities list. But, as is typical, this is precisely why our clients come back to us time and again when they need expert counsel. Our top New York City tax attorneys spend their professional time concentrating on difficult matters such as these so that our clients don’t have to worry about them. If you have a question about the tax consequences of selecting an entity, or any other business or tax issue, contact the firm of Mackay, Caswell & Callahan, P.C., and we will give you assistance right away.