In the wake of the Tax Cuts and Jobs Act, business owners nationwide are looking closely at whether incorporating as an S corporation or a C corporation will offer a greater reduction in their tax burdens over the long haul. While C corporations pay corporate taxes to the IRS, S corporations don’t have any entity tax — rather, taxes are paid via individual returns. “An S corp does not have a legal responsibility to pay taxes on its own — the owners of the company pay taxes on their income,” explains Scott Greenberg, senior analyst with the Tax Foundation, an independent Washington, DC think tank.
The 2018 tax law was beneficial to both types of companies. Tax rates for C corporations were slashed from 35 percent down to 21 percent. (Their dividends are taxed again at the individual level, with a top rate of 23.8 percent, resulting in a top effective rate of 39.8 percent, but the timing of those dividends is at the company’s control. More on that in a moment.) S corporation owners may benefit from a 20 percent deduction of pass-through income, reducing their effective tax rates from 37 percent to 29.6 percent (subject to certain income, wage, and property limitations).
Rarely are there one-size-fits-all answers during tax season, and that is certainly true when comparing these two types of incorporation. But understanding the three major areas of difference between the two — ownership restrictions, shareholder rights, and taxation — can help. What’s best for your business depends entirely on company structure and growth plans. Here’s a breakdown.
“C corporations have no restrictions on ownership — they can have an unlimited number of shareholders— while S corporations can only have up to 100 shareholders,” explains Andrew Oswalt, CPA and tax analyst for TaxAct.
S corporations must also be domestic (the company and its owners must live in the United States), with shares held by individuals, estates, or certain trusts (not other companies). And there can only be one class of stock (so you can’t issue preferred shares as well as common ones, for example.)
“Let’s say you have a tech startup and you’re hoping that the company is going to grow and go public,” says Barbara Weltman, author of JK Lasser’s Small Business Taxes 2018. “It might make sense to be a C corp, because of what you’ll be looking to do in the future, like equity crowdfunding, or looking beyond that, going public.”
Shareholder rights differences
Because C corps can issue common stock and preferred stock, it’s possible for some shareholder votes to matter more than others, Oswalt explains. The fact that S corps can only have one class of stock and one kind of shareholder levels the playing field.
You may have heard that C corps are subject to “double taxation,” which means the company pays a corporate tax, and then the owners of the company are also taxed on the income they make from the company. “This is the downside of C corps,” Weltman says. “But in 2018, the 21 percent rate is going to be a boon to a lot of people. That’s a flat rate, so the mom and pop dry cleaner on the corner is paying the same rate as would Amazon and every other Fortune 500 company.”
Simultaneously, C corps have other tax benefits that S corps don’t share, Greenberg explains. “An S corp shareholder will pay taxes in the year their money is earned, but a C corp shareholder will only pay taxes on their business income when the business distributes dividends or when shareholders realize a capital gain, so there can be flexibility on when you pay your taxes, and when you get paid.”
What it comes down to is this…
Small businesses may want to be an S corporation, especially if the only owners are domestic individuals. But if you really plan on growing the business over time and adding shareholders, a C corporation may be the best choice.
If you don’t plan on paying yourself a dividend for a long time — years not months — a C corp may be the better choice because you’ll only be taxed at the 21 percent level until then. “You don’t get taxed at the individual rate until a dividend is paid,” Oswalt says. “And who knows, ten years from now, the individual rate could be even lower… or higher, depending on who’s in control in DC.”
Still unsure which direction to go? Here’s a quick checklist of the pros and cons:
- Both S and C corps have limited liability.
- Both S and C corps have perpetual existence – if the owner/shareholder passes away, the corporation continues to exist.
- C corps have no shareholder limit, while S corps have limited ownership options (including the fact that S corps cannot be owned by individuals living outside the US).
- C corps can be owned by other C corps.
- C corps can deduct fringe benefits, like disability and health insurance.
- C corp owners can’t write off losses on their personal return, while S corp owners can.
- It may be easier to grow as a C corp.
- S corps must pay a “reasonable wage” to employee-shareholders, and this is one item the IRS scrutinizes.
With Kathryn Tuggle. This blog by Jean Chatzky is in partnership with TaxAct.