One of the top priorities of every business is to create value for its shareholders. This holds true whether the business has one shareholder or 100 shareholders. Both the corporate structure and tax designation of a business can affect many areas that drive shareholder value, including the ability to raise capital, the ability to structure equity offerings and especially tax liability. Choosing both the right corporate structure and tax filing status is an important decision with broad-reaching implications. Here is a closer look at the specific differences between C-corporations and S-corporations, and the most important decision-driving factors for making the right selection.
The difference between a C-corporation and an S-corporation
The main difference between a C-corporation and an S-corporation is how the business is taxed. Income from a C-corporation is taxed twice. First, the C-corporation is taxed on its net income at its corporate tax rate. After paying taxes at the corporate level, shareholders pay dividend tax on distributions. Conversely, an S-corporation is only taxed at the shareholder level at the individual income rates.
It would appear that being taxed once is always better than being taxed twice. However, just because an S-corporation is taxed once does not make it the right choice for every business. Currently, the top individual tax rates are higher than the corporate tax rates, which can complicate the analysis for businesses looking to reinvest or keep income in the company. Additionally, the availability of incentives, ownership limitations and capital requirements can make it difficult to determine which election is the best choice for your organization. The individual circumstances of each organization must be taken into consideration.
What businesses are eligible for S-corporation status?
The S-corporation election was created as a filing option for small businesses. An S-corporation must have a calendar fiscal year, can only include U.S. citizens and resident aliens as shareholders, and must have no more than 100 shareholders. An S-corporation also does not have the ability to issue different classes of stock. Therefore, if a company has a large number of shareholders, may seek outside funding or has foreign ownership, it is not a good candidate for S-corporation status.
How should a company decide if a C-corporation or S-corporation is best for them?
Companies that may seek private equity investments, want to expand quickly, have large numbers of shareholders, need multiple stock classes or are planning a public offering are usually best filing as C-corporations.
For smaller, closely held or family businesses, S-corporations are often preferable. These businesses often realize significant tax savings by filing for S-corporation status, especially around the time of start-up, as net operation losses sustained can be passed to the personal level instead of being stuck within the corporation.
Any filing election decision, whether at the time of formation or later in the life of a company, should be made based on the specific needs and conditions of the business after a discussion with a qualified advisor.
Changing an election
To make an initial S-corporation election, an existing business must file Form 2553 with the IRS. If filed within 75 days of establishing the business, there are no extra tax ramifications.
Converting from an S-corporation to a C-corporation is fairly simple. However, be aware that once a business gives up their S-corporation election, they cannot go back to being an S-corporation for five years.
Shifting from a C-corporation to an S-corporation, however, is a little more difficult, due to different accounting rules for S-corporations. For the five years following conversion, when gains are recognized on net unrealized ‘built-in gains’ from the C-corporation, they are subject to the highest corporate tax rate of 35 percent. That means that in certain cases a major tax liability can be caused by selling a business within five years of converting to an S-corporation.
Seek counsel before making an important decision
Deciding on filing as a C-corporation or an S-corporation is an important decision for any company. Many factors – past, current and future should be considered before making or changing an election. If you are making an initial election or considering changing your filing status, we can help. Call our office today to set up a consultation.