Tax Implications of S-Corporations and C-Corporations

Small business owners often struggle with the decision of which type of legal structure to adopt when incorporating their company. That’s because S-Corporations and C-Corporations are governed by different laws and regulations regarding everything from ownership eligibility to stock distribution, and choosing one or the other could have a profound impact on future profits and growth. There are also different tax implications associated with the two types of corporations, which is something we will examine more closely here.

Income taxes

C-Corporations are standalone entities in the eyes of the law, and are therefore assessed federal taxes at the corporate tax rate on all business earnings. Losses may be used to offset past or future business income for accounting and tax purposes.

S-Corporations, on the other hand, are pass-through entities. As such, earnings and losses are recorded on shareholders’ individual income tax forms, with earnings assessed at personal tax rates and losses used to offset other income on the individual return (assuming certain minimum requirements are met).

Ownership eligibility and restrictions

U.S. tax regulations impose certain eligibility requirements and restrictions on ownership within S-Corporations and C-Corporations. For example, S-Corporations are allowed to have a maximum of only 100 owners, all of whom must be American citizens or reside in the United States. Conversely, C-Corporations have no such limitations on the number, citizenship status, or residency of owners.

Stock classes and dividends/distributions

Additional differences between S-Corporations and C-Corporations arise when dealing with stock classes and dividends (i.e., distributions paid out to shareholders). Specifically, S-Corporations may only have one stock class, thus giving all shareholders equal rights in terms of dividends and liquidation. Moreover, in many cases the IRS views S-Corporation dividends as a return on money previously invested in the company, which may essentially eliminate income taxes on those funds.

C-Corporations, meanwhile, may issue different classes of stock (e.g. common and preferred) that offer different rights and privileges to shareholders. Furthermore, since U.S. tax rules require that C-Corporation stakeholders declare dividend income on their personal tax returns, the possibility of double taxation—once at the corporate level and again at the individual level—exists.

Choosing to incorporate as an S-Corporation or a C-Corporation is a major decision that must be considered in light of a number of legal and financial variables, including taxation. If you are currently wrestling with this problem, you might benefit from time with a tax expert, so call us at (919) 420-0092 or fill out the form below.