C-corp vs. S-corp: How to decide between a C-corp or S-corp designation
Every business, regardless of size, desires to maximize value to its shareholders. And maximizing value usually means minimizing tax liability. For many businesses, the decision between filing as a C corporation versus S corporation can have a significant effect on overall tax liability, and by extension shareholder value.
“As a business owner, you should be asking yourself, ‘Is our filing status maximizing shareholder value?’ If you’re not sure, it is probably time to talk to a professional,” says Wonsun Willey, tax partner at Sensiba San Filippo LLP.
Smart Business spoke with Willey about the benefits of C-corps and S-corps.
What makes an S-corp different from a C-corp?
C-corps and S-corps both provide the same legal benefits. The difference lies in how the corporations are taxed. Income from a C-corp is actually taxed twice. The C-corp itself is taxed on its net income at its corporate tax rate. Then, after paying tax at the corporate level, shareholders also pay dividend tax on distributions. Income from an S-corp, on the other hand, is only taxed at the shareholder level at individual income tax rates.
Common sense would indicate that it’s better to be taxed once rather than twice. In many cases, that’s exactly right. But it’s not always that simple. Variances in tax rates, the availability of incentives, ownership requirements and investment opportunities can cloud the picture. There isn’t one ‘right answer’ that applies to every organization, but there is almost certainly a right answer for your organization.
What businesses are eligible for S-corp status?
S-corp filing status is intended as a filing option only for small corporations. An S-corp can have no more than 100 shareholders, can only include U.S. citizens and resident aliens, and must have a calendar fiscal year. An S-corp also does not have the ability to have different classes of stock. So organizations that have foreign ownership, a large investor group or that may seek private equity investments are not good candidates for S-corp status.
What is involved in making or terminating an S-corp election?
Making the S-corp election is relatively simple. An existing corporation must file a Form 2553 with the IRS. If the election is made within 75 days of formation of the corporation, there are no additional tax ramifications.
Converting a long-established C-corp to an S-corp can be more complicated. The accounting rules for S-corps are different, often making the conversion a cumbersome task. An S-corp can also face additional tax on net unrealized ‘built-in gains’ from the C-corp. Gains recognized during the 10 years following conversion are subject to the highest corporate tax rate of 35 percent. Selling a business within 10 years of converting to S-corp status can trigger a substantial tax liability.
Changing from an S-corp back to a C-corp has fewer challenges, but should be carefully considered before action is taken. Once you give up your S-corp election, you can’t go back to being an S-corp for five years.
How should a business decide which status is best?
For many small businesses, especially start-ups, S-corps are clearly preferable. They provide significant tax savings and any losses incurred can be passed through to the personal level rather than being trapped within the corporation. Businesses seeking outside funding, looking for rapid expansion or needing multiple stock classes are limited to C-corp status.
Small C-corps that meet the requirements for S-corp status frequently benefit from making an S-corp election, even years after formation. Ultimately, the decision should be made based on the individual circumstances of the organization following consultation with a qualified adviser.