Suppose you’ve decided that you want to form your new business as a corporation (not an LLC), and you are trying to figure out if it should be an S Corp or a C Corp. How do you decide? Flip a coin? Arm wrestle your co-founder? Rely upon your lawyers or CPAs advice? The following is a high level summary of some of the more important federal income tax and non-tax considerations involved in choosing between doing business as an entity taxed for federal income tax purposes as:
- a C corporation (C Corp) vs.
- an S corporation (S Corp); and
I generally don’t recommend a coin toss as the method of deciding. Hopefully, the pros and cons listed below will help you.
C CORPORATION ADVANTAGES/S CORPORATION DISADVANTAGES
- Traditional Venture Capital Investments Can Be Made – C corporations can issue convertible preferred stock, the typical vehicle for a venture capital and angel investment. S corporations may have a single class of stock only and therefore cannot issue preferred stock.
- Retention of Earnings/Reinvestment of Capital – Because a C corporation’s income does not flow or pass-through to its shareholders, C corporations are not subject to pressure from their shareholders to distribute cash to cover their shareholders’ share of the taxes payable on account of taxable income that passes through to them. An S corporation’s pass-through taxation may make conservation and reinvestment of operating capital difficult because S corporations typically must distribute cash to enable shareholders to pay the taxes on their pro rata portion of the S corporation’s income (S corporation shareholders are taxed on the income of the corporation regardless of whether any cash is distributed to them).
- No Single Class of Stock Restriction – S corporations can only have one economic class of stock; thus, S corporations cannot issue preferred stock. This restriction can arise unexpectedly, and must be considered whenever issuing equity, including stock options or warrants. (S corporations can, by the way, issue voting and non-voting stock, as long as the stock is economically the same class.)
- Flexibility of Ownership – C corporations are not limited with respect to ownership participation. There is no limit on the type or number of shareholders a C corporation may have. S corporations, in contrast, can only have 100 shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders (all shareholders must be U.S. residents or citizens).
- Eligibility for Qualified Small Business Stock Benefits – C corporations can issue “qualified small business stock.” S corporations cannot issue qualified small business stock, thus S corporation owners are ineligible for qualified small business stock benefits, such as the 50% gain exclusion for gain on the sale of qualified stock held for more than five (5) years (for an effective capital gains rate of 14%) and the ability to roll over gain on the sale of qualified stock into other qualified stock. Currently, for C corporations acquired before the end of 2013, this exclusion is 100% (subject to a generous cap).
- More Certainty in Tax Status – A C corporation’s tax status is more certain than an S corporation’s; e.g., a C corporation does not have to file an election to obtain its tax status. S corporations must meet certain criteria to elect S corporation status; must elect S corporation status; and then not “bust” that status by violating one of the eligibility criteria.
- Avoidance of Shareholder State Income Tax Problems – Shareholders of an S corporation may be subject to income taxes in states in which the S corporation does business.
S CORPORATION ADVANTAGES/C CORPORATION DISADVANTAGES
- Single Level of Tax – S corporations are pass-through entities: their income is subject to only one level of tax at the shareholder level. A C corporation’s income is taxable at the corporate level and distributions of earnings and profits to shareholders (i.e., dividends) that have already been taxed at the C corporation level are also taxable to the shareholders (i.e., the dividends are effectively taxed twice). This rule is also generally applicable on liquidation of the entity.
- Pass-Through of Losses – Generally losses, deductions, credits and other tax benefit items pass-through to a S corporation’s shareholders and may offset other income on their individual tax returns. These returns are subject to passive activity loss limitation rules, at risk limitation rules, basis limitation rules, and other applicable limitations. A C corporation’s losses do not pass through to its shareholders.