by Craig D. Hasenbalg and Alexandra Verven (Fall 2017)
One of the first decisions any business owner is often confronted with is just what type of entity to use when operating the business. These days, the law offers a number of somewhat overlapping alternatives. They include partnerships, limited partnerships, corporations, limited liability companies, and the list can go on. This article will analyze two similar but very different types of corporations – a “C” corporation and an “S” corporation, which are (and have been for years) very popular choices.
The primary motivation for incorporating a business in the first place is to insulate the owner or owners from third-party liabilities. When business is operated through a corporation, and the corporate entity is properly maintained, third-party creditors may seize the corporation’s assets to satisfy a liability, but the creditor cannot touch the personal assets of the business owner. Both C corporations and S corporations provide their owners this type of creditor protection. Apart from this basic similarity, however, the two types of corporations bear little resemblance to each other.
The capital structure of a C corporation is typically more investor-friendly than an S corporation. For example, C corporations can have common and preferred stock. C corporations can also have multiple types of common stock, each granting its owners different bundles of rights. The same can be true for preferred stock. S corporations, on the other hand, can have only one class of stock, although S corporations can have common stock as well as non-voting common stock under the current rules. That provides for some flexibility, but not nearly as much as with C corporations.
The taxability of C versus S corporations is the most frequently mentioned difference between the two types of corporations. C corporations are subject to “double taxation.” C corporations are separate, stand-alone taxpayers, meaning that when a C corporation earns a dollar of income, the C corporation itself must pay tax on that dollar. If the owners of the C corporation wish to put the remaining after-tax money into their pockets, the C corporation must declare a dividend. Shareholders, however, must pay tax when they receive that dividend. Because the same dollar of income is taxed at the corporate level and then again at the shareholder level, a C corporation is said to be subject to double taxation.
With S corporations, however, the corporate entity is not itself a separate taxpayer. Consequently, S corporation income is not taxed at the corporate level. Instead, a dollar of income (whether it is distributed to the shareholders as a dividend or not) “passes-through” the S corporation and is included in the taxable income of the shareholders, to be taxed at each shareholder’s individual tax rate. Because a dollar of S corporation income is only taxed one time, absent unusual circumstances (and assuming the amount of income earned is equal), there is typically more income left over when the income is earned by an S corporation.
For most small businesses, choosing to be an S corporation is preferable, but some emphasis must be placed on word “small.” A business cannot operate as an S corporation if it has more than 100 shareholders. Additionally, there are limitations on the characteristics of a qualified shareholder in an S corporation. All shareholders of an S corporation must be U.S. citizens and, in general, the shareholders must be natural individuals, although there are certain types of trusts that are permitted to hold stock in an S corporation.
On the whole, most small businesses find the advantages of an S corporation (especially the single level of tax) to be preferable to operating as a C corporation. However, if the business owners have great plans to grow the business into a significant enterprise with complicated and diverse capital structure, there often is no alternative but to conduct the business as a C corporation.