C-Corporations and S-Corporations are two of the most popular company structures used by small businesses in the United States today. Both structures provide certain tax benefits that can help your business save money on taxes, but they also have unique benefits and drawbacks that can make one structure better than the other depending on your business's needs. With many options when it comes to tax structures when starting a business, you want to make sure you choose the right one for you.
Don’t rely on tired advice from others who don't understand your situation perfectly. There are a lot of nuances to different company structures that’s almost impossible to figure out all on your own.
As an aspiring entrepreneur, this dilemma can seem daunting and overwhelming at first glance. But fear not! We're here to break down some important information about company structures so that you make sure your company is set up for success from day one.
In a nutshell, the three most common types of legal structures are sole proprietorships, LLCs, and C-corps, all with their own benefits and shortcomings. A sole proprietorship can be easy to start and allows you to collect all of the profits as the owner, however, you also open yourself up to liability.
LLCs are the next step up in company structures that separate you from the company to provide limited liability. They have a simple management structure and tend to be easier to set up than a corporation, however, LLCs often pose a different tax approach and you may miss out on opportunities to attract investors. For a more in-depth review of these two types of structures, check out our article here.
Let's say you want a more formal management structure and are looking into either an S-corp or C-corp structure. Both options offer different advantages for growth in a company but they drastically differ in their functionality.
However, what is the difference between the two? Does it matter which one I pick? And who would benefit more from which? This article will answer all your questions and more.
What is a C-Corporation?
With C-Corp being the most common option for large businesses in the US, it's very likely that you've heard of it before. Large corporations like Walmart, Microsoft, and Apple use this type of corporate structure because of its potential for growth.
C-corps provide limited liability and act as a separate legal entity from the owner. With a C-Corp you can have unlimited shareholders, which makes it the popular choice for a company that expects to go public.
Tech companies are especially attracted to C-corps, as they usually need a lot of funding . Venture capitalists often feel more inclined to invest in a C-corp as it shows a larger potential for return on their investment. This makes it a natural option for large businesses looking for heavy investment and uncapped growth.
There are disadvantages to a C-corp, however, especially for smaller business owners. The biggest one is double taxation on income and earnings. Double taxation is when taxes get paid twice on the same source of income.
How it often goes is that your business income will get taxed first at the federal corporate income tax. States may also impose a corporate income tax that varies as well. For small business owners, this can be unnecessary. If you don’t plan on having more than 100 shareholders or going public, a C-Corp may not be right for you.
Consider the following example where the current corporate tax rate is a flat 21% and the federal income tax rate is 20%:
In this simplified example, you can see the business owner is taxed twice in a C-corporation structure. From your revenue and cost of goods sold (COGS), you get your gross profit. Operating expenses which includes things like rent, marketing, and salaries, are then deducted from the gross profit to give you income from operations. After the expenses are subtracted you will get taxed by the federal corporate tax rate to result in the corporation’s final net income.
As a C-corp, the taxes end here for the corporation. However you as a business owner receive dividends from the company and that will be taxed at your personal tax rate. As a separate legal entity, you will get taxed again on your personal tax forms.
If a C-Corp is necessary for your business, there are ways to reduce income tax, however this will require the eye of a professional tax advisor. For small businesses, there are affordable bookkeeping services out there that will save you time and money in the long run.
Another disadvantage is that C-corps can be expensive to register. Not to mention factors like annual minutes and the fact that most tax prep firms charge a higher price for corporate returns than a personal return with a Schedule C as a corporation. There are also increased regulations and formalities that impose a steep learning curve on business owners.
An S-corp is unique to a C-corp as they are generally more common for small businesses. S-corps act as a flow-through entity, which means all profits and losses of your company will pass through the corporation to you, and you can avoid double taxation. This is generally enough for small business owners to choose an S-corp over C-corp, however, there are other things to consider.
An S-corp also has more credibility over a sole proprietorship, all the while creating tax benefits for the owner. On top of avoiding double taxation, shareholders can receive salaries as employees which can reduce the amount of tax they have to pay. Consider the following example for an S-corp where the same business tax rate of 21% and federal income tax of 20% applies:
S-corps still have their drawbacks as well. First of all, you must be a U.S. citizen or permanent resident to apply for an S-corp, which is not required by C-corps. There is a maximum shareholder limit of 100 shareholders, which can limit the company’s growth potential. Lastly, S-corps may require careful bookkeeping and finances to avoid IRS scrutiny and make tax qualifications.
Choosing a company structure can be scary, as it depicts the future of your business. However, having a proper understanding of the differences between them can let you choose the optimal structure for your business goals and needs. This can save you time, effort, and even money in the long run!
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