How to Choose Between S Corp vs C Corp for a Startup
When launching a new business, you’re going to make a lot of critical decisions in a short space of time. Unfortunately, rushing through tax questions is one of the most expensive mistakes entrepreneurs make. Let’s explore the pros and cons of S Corp vs C Corp for startups to guide you toward the best structure for long-term success.
Technical Note: The designations of C and S for a business refer to how the entity is taxed at the federal level. These categories come from Subchapters C and S of Title 26 of the U.S. Code. It never ceases to amaze me how many people confuse a tax election (C or S) with a legal structure (corporation, LLC, partnership).
TABLE OF CONTENTS
- What is a C Corporation?
- What is an S Corporation?
- What’s the Advantage of a C Corp vs S Corp?
- Let Us Help You Make the Right Call
What is a C Corporation?
C Corporations (C Corps) are separate entities from their owners and are taxed separately. The corporation is subject to both state and federal corporate income tax, and any dividends paid to shareholders are also taxed on their personal tax returns. This double taxation is the reason many people have chosen to avoid the traditional corporate structure.
What is an S Corporation?
An S Corporation (S Corp) is not subject to federal income tax at the corporate level. Instead, any income, losses, deductions, and credits flow through to shareholders and are reported on the shareholders’ individual tax returns.
As you may imagine, S Corp status is particularly attractive to small business owners hoping to minimize corporate tax, since this structure avoids the double taxation associated with C Corps. However, companies have to meet specific criteria to qualify for S Corp status. If you’re not a US citizen or permanent resident – your business cannot elect S Corp status. Also, certain trusts are not permitted to be S corp shareholders.
What’s the Advantage of a C Corp vs S Corp?
While the potential for double taxation is the cost of doing business as a C Corp, there are plenty of benefits. When small businesses, sole proprietorships, or partnerships qualify for both structures, consider the following factors in the S Corp vs C Corp dilemma:
Growth Forecast
S Corps are limited to 100 shareholders or fewer, all of whom must be citizens or residents of the United States. C Corps have no restrictions as to the number of shareholders, making them an appealing option for companies looking to expand quickly.
Investor Interest
S Corporations are allowed only one class of stock, but C Corps can offer various classes. Stock options can help you at every stage, from raising capital to hiring employees to going public. This is a no-brainer in S Corp vs C Corp for startups: you have more leverage to structure deals with venture capitalists and angel investors.
Employee Benefits
C Corps can provide more extensive employee benefits, such as equity in the company and retirement plans, which can help attract and retain leaders in the field. C Corp structure may lend additional credibility to your startup, especially when pulling in high-end talent.
Tax Flexibility
While C Corps face double taxation, they can also take advantage of a lower corporate tax rate on profits. This can be beneficial if the company reinvests its earnings instead of distributing them as dividends.
Owner Compensation
This one tends to surprise many people. If you’re the owner/operator of an S Corp, the IRS requires that you be paid reasonable compensation for your services to the company. The definition of reasonable compensation is a bit in flux these days. Older paradigms of splitting the owner’s compensation between earned income (W2) and distributions (K1) have floated between 25/75 to 50/50. In recent years, many advisors are recommending the use of a reasonable compensation study to establish what the owner/operator’s ratio of salary to distributions should be. The IRS is increasing its enforcement of reasonable compensation because it means higher collections for federal withholding, social security, and medicare taxes.
Let Us Help You Make the Right Call
As a Florida business lawyer, I’ve seen the damage that bad corporate tax planning can cause. Believe me, you don’t want an expensive error lurking in your documents waiting to go off. Whether you want an LLC taxed as an S Corp vs a C Corp, a new operating agreement, or other legal matter, we review your existing paperwork and draft new contracts to protect your interests. Email Yolofsky Law at [email protected] today or schedule a 15-minute call to get started.