If you’re starting a business, you’ve probably heard there are good reasons to set it up as its own entity instead of running it as a sole proprietorship. Having a separate business entity goes a long way toward preventing business losses from affecting your personal assets, and there are tax advantages that may apply as well.
You’ve probably also heard that your main options when selecting a business entity are to set up as a partnership, a corporation, or a limited liability company or LLC, although there are a number of options. If you’ve decided that incorporation is the best choice for you, however, the question still remains whether you want it to be a C corporation or an S corporation.
Never heard of these? That’s not surprising. Many people gloss over those letter designations and, if they do, the issue may never come up again. That’s because if you don’t make a choice between S or C, your corporation is automatically a C.
You ought to choose, and the reason is taxes.
Both S and C corporations limit your liability. They are both set up via Articles of Incorporation, are owned by shareholders who are issued stock, and governed by officers and directors. The difference between the two is how they are treated by the IRS.
The income earned by C corporations is taxed twice by the IRS — once through the corporate tax and a second time when shareholders receive distributions. S corporations are only taxed one time — by the shareholders.
That makes a great deal of sense for small companies, and indeed S corporations can have no more than 100 shareholders, who generally must be individuals who are U.S. citizens or lawful permanent residents. There are also some constraints on stock classes and operational issues. The only downside to setting up as an S corporation from the beginning is that the accounting rules are somewhat more complicated.
It’s a great deal more complex, however, to begin as a C corporation and then convert to an S more than 75 days later. First, those additional accounting requirements and second, corporate taxation during the conversion can be complicated and additional taxes may be owed.
If you’re interested in selecting an S corporation as your business entity, you should get good legal and tax advice to help you realize your plans as efficiently as possible.
Source: Forbes, “C or S Corporation Choice is Critical for Small Business,” Robert W. Wood, May 3, 2012