Differences Between C Corporations & S Corporations

Federal taxation

A C corporation is taxed as a separate entity and must report profits and losses on a corporate tax return. The C corp pays corporate taxes on its profits, while the shareholders are not taxed on the corporation’s profits. Shareholders report and pay income taxes only on what they are paid by the corporation.

When the C corporation chooses to pass along any of its after-tax profits to shareholders in the form of dividends, the shareholders must report those dividends as income on their personal tax returns even though the corporation has already paid corporate taxes. This is commonly referred to as “double taxation” – something that is avoided with an S corporation (a pass-through tax entity).

While an S corp with more than one shareholder does file an informational K-1 tax return, the corporation itself does not pay any income taxes. Instead, the individual shareholders (owners) must include their share of the corporation’s profits on their personal tax returns, paying tax at their individual tax rate.

S corporations provide another advantage should the corporation experience losses. Unlike C corporation shareholders, S corp shareholders are allowed to offset other income by including their share of the corporation’s losses on their personal tax returns provided; however, they cannot deduct corporate losses in excess of their "basis" in their stock – that being the amount of their investment in the company, with a few adjustments.

Keep in mind that no more than 25% of an S corporation’s gross corporate income may be derived from passive income.

State taxation

While states generally treat S corporations the same as the federal government, there are exceptions.

For instance, some states simply do not recognize S corporations. You can still have an S corporation in the state and enjoy the federal tax savings, but the business is an S corp for federal tax purposes only – not for state tax purposes, where the corporation will be treated as a regular C corporation.

A few states tax both the S corp’s profits as well as the shareholders’ proportional shares of the S corporation’s profits. In such states, the S corporation is double-taxed in a manner similar to a C corporation that paid all of its profits as dividends.

Other states tax S corporations on only part of their income even though they do recognize the S corp.

These are just a few of the many ways states tax S corporations. With so many variations, you’ll want to avoid any surprises. Prior to submitting an S corp electing, find out exactly how the state in which the corporation will operate treats S corporations. Consult with your tax advisor or contact the state income tax agency to determine whether a separate S corporation election form is required for the state and what, if any, state taxes apply to S corps.

Compensation of officers

The IRS requires that owner-employees of an S corporation be paid wages and that the salary paid an owner-employee be a “reasonable amount” for the work being performed. Of course, that means employee-owners cannot avoid paying payroll taxes by paying themselves nothing. And their salaries will be subject to payroll taxes, even if the corporation is losing money.

Employee benefits

While both C corporations and S corporations are allowed to provide employee benefits that are deductible by the corporation and tax-free to the employees, the tax-free status of some fringe benefits is not nearly as generous for S corp shareholders who own more than 2% of the corporation’s stock.

Capital accumulation

Since the corporate tax rate is typically lower than an individual’s tax rate and profits retained in the corporation will not be double taxed as dividends, a C corporation can generally accumulate capital more effectively than an S corporation.

Of course, an S corporation could accumulate even more capital if it did not distribute any of its profits to the shareholders, but doing so would create obvious problems for some owners who would have to pay income taxes on this “phantom income” which they did not actually receive.

Stock/ownership

Each S corporation shareholder must be a U.S. citizen or resident. C corporations can have multiple classes of stock, while S corps are limited to one class of stock (voting rights can differ).

Business activity

S corporations are not allowed to conduct certain kinds of business. Business corporations that are not eligible for S corp status include banks, insurance companies taxed under Subchapter L, Domestic International Sales Corporations (DISC), and certain affiliated groups of corporations.

Corporation size

Generally speaking, C corporations offer more flexibility than S corporations and are therefore the best choice for large companies with a large numbers of shareholders, especially if they are publicly traded.

Fiscal year

C corporations can choose when their fiscal year ends, while an S corporation’s fiscal year end must be December 31st. If a C corp has been using a fiscal year end other than December 31, it must change to a December 31 fiscal year end if it converts to an S corp. And if the S corp status is later revoked, it cannot change from the 12/31 fiscal year.

Accounting method

Medium or large C corporations ($5,000,000 or less in gross receipts) are required to use the accrual method of accounting, while only those S corporations with inventory must use the accrual method of accounting.

Conversion from C corp to S corp

A C corporation can make its original conversion to an S corporation at any time after being originally formed by filing a Form 2553 with the IRS. A few states require that an S election also be filed with the state. In cases where a C corp is converted from an S corp, it must remain a C corp for at least 5 years before it can be converted back to an S corp.

Conversion of an S corp back to a C corp

An S corporation can convert back to a C corporation anytime by filing a formal request with the IRS. However, the C corp must keep the December 31 fiscal year end and it cannot convert back to an S corp for at least five years (restrictions that hamper the ability to save taxes by shifting income between taxable years – a strategy practiced by some). It can sometimes be more beneficial to form a brand new C corporation rather than converting.