S Corp vs C Corp: How Should You Incorporate Your Small Business?

S Corp vs C Corp: How Should You Incorporate Your Small Business?
Amy Fontinelle
on July 3, 2017
Read in 8 min

Before we understand the difference between an S Corp vs C Corp, we must first ask ourselves: Why incorporate at all?

Many small business owners form corporations instead of sole proprietorships or partnerships because they want to limit their personal liability, save money on taxes, or both.

By default, if you incorporate your small business, it will be classified as a regular corporation, also known as a C corp.

However, you can choose to be an S corporation instead by filling out IRS form 2253.

But which type of corporation is truly best for your business?

To answer that question, you’ll need to understand what each type offers and how they are similar and different.

S Corp vs C Corp – The Basics of Incorporating

A corporation, whether C or S, is considered a separate entity from its owners.

A sole proprietorship or partnership, by contrast, is one and the same as its owners.

Separating yourself from your business by forming a corporation limits your risk of losing personal assets if your business is unprofitable, can’t repay a debt, or gets sued.

It also means that your business will pay taxes separately from you as an individual and that your business may benefit from certain tax breaks available only to corporations.

As a sole proprietor or a partner in a partnership, all of your business profits are considered personal income, and all profits are subject to self-employment taxes because you are considered self-employed.

As the owner of a corporation, however, you will pay yourself a salary, which changes the math considerably.

How Corporate Earnings Are Taxed in an S Corp vs C Corp

Your salary as the corporation’s owner will often be smaller than the company’s total earnings.

You will leave some of the company’s profits in the company’s bank account for purposes such as business expansion.

These profits are called “retained earnings,” and they can help reduce your tax bill.

That’s because there’s a wide discrepancy between how personal income and corporate income is taxed.

The Trump administration is considering significant changes to both rates, but right now, the tax brackets look like this.

Personal Tax Rates, 2018

Tax rateSingleMarried filing jointly
10%$0–$9,325$0–$18,650
15%$9,326–$37,950$18,651–$75,900
25%$37,951–$91,900$75,901–$153,100
28%$91,901–$191,650$153,101–$233,350
33%$191,651–$416,700$233,351–$416,700
35%$416,701–$418,400$416,701–$470,700
39.5%$418,401 or more$470,701 or more

According to the table above, if you were single and earned $100,000 in profits as a sole proprietor, you would pay taxes as follows:

10% on the first $9,325, or $932.50

15% on the next $28,625 ($37,950 minus $9,325), or $7,155

25% on the next $63,275 ($91,900 minus $28,625), or $15,818.75

28% on the remaining $8,100 ($100,000 minus $91,900), or $2,268

for a total of $26,174.25.

Keep in mind, you’ll also pay self-employment taxes of 15.3% on your profits as a sole-proprietor.

Let’s see how these numbers change for an S corp or C corp below.

Corporate Tax Rates

If taxable income is...

overbut not over tax is of the amount over
$0 $50,000 15% $0
$50,000 $75,000 $7,500 + 25% $50,000
$75,000 $100,000 $13,750 + 34% $75,000
$100,000 $335,000 $22,250 + 39% $100,000
$335,000 $10,000,000 $113,900 + 34% $335,000
$10,000,000 $15,000,000 $3,400,000 + 35% $10,000,000
$15,000,000 $18,333,333 $5,150,000 + 38% $15,000,000
$18,333,333 . . . . . 35% $0

Now, let’s look at what you might do with $100,000 of taxable income as a C corporation.

First of all, you can’t leave 100% of your profits in the company.

If you keep too much money in the company (called “excess retained earnings,”) you may be penalized under the accumulated earnings tax if your company is audited.

The IRS requires corporate owners to pay themselves “reasonable compensation” given their duties and responsibilities in order to deduct those salaries as business expenses.

So let’s say you decide to pay yourself a salary of $80,000 and leave $20,000 in the corporation.

Your salary will be taxed at personal income tax rates:

10% on the first $9,325, or $932.50

15% on the next $28,625 ($37,950 minus $9,325), or $7,155

25% on the next $51,375 ($80,000 minus $28,625), or $12,843.75

for a total personal income tax bill of $20,931.25.

As you can see, now that you’re leaving $20,000 in your corporation, none of your income gets taxed at the 28% personal rate.

Instead, you calculate the rest of your tax using the corporate rate on $20,000, which is a flat 15%, or $3,000.

Your total tax bill on $100,000 as a C corporation instead of as a sole proprietor is $23,931.25 instead of $26,174.25, a savings of $2,243.

Your actual savings will be even greater since you don’t pay employment taxes on retained corporate profits.

But do keep in mind that you will pay employment taxes on $80,000, and your savings will be reduced somewhat by the time and money you spend on the legal requirements to form and maintain your corporation, such as annual filing fees and recordkeeping (though burdens can be lower in the two most corporate-friendly states: Nevada and Delaware).

If you structure your business as an S corp instead of a C corp, the tax calculation changes, as we’ll explain below.

S Corp vs C Corp – Similarities & Differences

An S corp is a type of pass-through entity, to use the business jargon.

Whereas a C corp pays some of its earnings to its owners and retains the rest of its earnings, an S corp passes all of its profits or losses through to its owners, where they are taxed at personal tax rates, not corporate tax rates.

You might have read that S corporation owners can avoid payroll taxes by paying themselves a small salary and taking the rest of their compensation as a “draw” or distribution that is not subject to payroll taxes, but court cases that the IRS has brought against small businesses show that the tax authorities often don’t approve of this tax avoidance strategy and will penalize business owners for it.

Through careful tax planning, you may be able to take distributions that will stand up to the IRS’s scrutiny, but you may need professional help to do so.

Don’t put yourself at risk of going out of business over tax penalties and interest you could have avoided.

At a minimum, you’ll need to pay yourself a salary similar to what you would make if you were performing your duties as an employee for someone else’s business (just like the reasonable compensation rule for C corps).

If there are excess profits left over and you follow the correct procedures, you may then be able to take distributions from your company without paying employment taxes on them.

As the owner of an S corp, then, whatever salary you pay yourself will be taxed at personal income tax rates.

The corporation will withhold your employee share of employment taxes and will also pay its matching share of employment taxes, just as a C corporation would.

You can avoid paying employment taxes on distributions, but you will still pay personal income tax on those.

Also, S corporations allow business losses to be used to offset personal income; C corporations don’t get that benefit. Ideally, you won’t have business losses, but for some startups, losses during the first few years are the norm.

Corporate Tax Deductions To Know

Many business deductions that C corporations and S corporations take are the same as the deductions that sole proprietors and partnerships take.

For example, both can deduct the cost of ordinary and necessary business expenses such as advertising, pension and profit-sharing plan contributions, and repairs and maintenance.

These deductions reduce business profits, reducing tax liability.

But corporations can also benefit from tax deductions that sole proprietors and partnerships can’t.

C corporations, but not S corporations, can deduct charitable contributions.

If you don’t itemize your deductions on Schedule A of your personal tax return, you can’t deduct charitable contributions from your personal income taxes.

Making contributions through your C corporation instead, could lower your tax bill.

Tax-exempt fringe benefits are another unique benefit for C corporation owners, C corporation employees, and S corporation employees who do not own more than 2% of the company.

Such benefits may include a cell phone, educational assistance, dependent care assistance, and small gifts.

Business owners can deduct the full cost of these fringe benefits as business expenses,  and the value of those benefits is not taxable to the individuals who receive them.

Other Key Differences between an S Corp vs C Corp

Aside from tax rates and tax deductions, there are some other differences between the two types of corporations that might cause you to choose one over the other, though most only matter for sizeable companies.

Shareholder Constraints

An S Corp can’t have more than 100 shareholders; a C corp can have unlimited shareholders.

If you’re certain you’ll go public one day and you don’t want to change your business structure later, forming a C Corp now might make sense.

Citizenship Requirements

All S Corp shareholders must be US citizens or residents, while a C Corp can have shareholders that are foreign corporations or nonresident aliens.

Business Acquisition

S Corps can’t be owned by most other types of entities, but a  C Corp can — a possible advantage if you hope your company will be acquired at some point.

Stakeholders Rights

S Corps can only have one class of stock where all shareholders have equal voting rights.

C Corps can have different classes of stock with different voting rights.

Taxation

As we touched on earlier, C Corporations (but not S corporations) face double taxation.

When they pay earnings to shareholders as dividends, those dividends are taxed twice.

Dividends are paid out of profits that have already been taxed as income to the corporation, and dividends are not a tax-deductible business expense.

The shareholders who receive those dividends then pay personal income tax on them at a rate of 0% to 20% depending on the individual’s tax bracket.

If your C corporation doesn’t pay dividends to shareholders, you don’t need to worry about double taxation.

Finally, a few states do not tax S corporations differently than C corporations, so tax benefits at the state level may be reduced for companies that do business in those states. Also, a few states, such as Texas, don’t tax personal income, while a few others, such as Washington, don’t tax corporate income.

Corporate Responsibilities

Whether you decide to operate your business as an S corporation or as a C corporation, you may have new responsibilities that you didn’t if you previously operated as a sole proprietorship or partnership.

These include holding annual meetings of directors and shareholders, keeping minutes of major company decisions, signing documents in the corporation’s name rather than your personal name, keeping your corporate and personal finances separate, keeping detailed business financial records, and filing a corporate tax return.

But before you do any of that, you’ll need to file articles of incorporation with your state (which you can usually accomplish by completing a simple state-supplied form) and pay a filing fee of around $100.

You’ll also need to write corporate bylaws that explain how your corporation is run.

You don’t have to file your bylaws with the state, but you’ll want to have them on file to lend legitimacy to your business structure and preserve your limited personal liability and potential tax benefits if your corporate status ever comes under scrutiny.

Another key step is issuing stock to each of your corporation’s shareholders and indicating what percentage of the business each share represents.

If you’re the sole owner, it’s easy:

You own 100% of your corporation’s stock – an S Corp vs C Corp makes little difference here.

If you have co-owners, you’ll need to divvy up the stock in way that you all agree upon.

Corporations may also need to make estimated tax payments during the year, and if they have employees, they must pay Social Security, Medicare, and federal unemployment tax.

They must also withhold employees’ payroll taxes and send that money to the IRS.

S Corp vs C Corp – The Bottom Line

Whether you choose to structure your business as an S Corp vs C Corp, incorporating can offer limited liability and tax savings compared with operating as a sole proprietorship or partnership.

A C corporation may be better for businesses that have big growth plans, though this structure can benefit businesses that plan to stay small, too.

Becoming a corporation can be especially valuable if your company engages in risky activities, if you have significant personal assets to protect, if you want to offer stock options to help attract and retain talented employees, or if you want to offer considerable fringe benefits.

A third option not discussed in this article is to form an LLC, which gives you some of the advantages of incorporation with less complication.

This is particularly popular among small business owners who are serious about long-term growth and want to keep their personal name separate from the business.

Whether you choose to incorporate as an S Corp vs Corp is entirely up to you, but whatever you choose, be sure to review the effect that each will have on your bottom line.

Should you need access to working capital for your new corporation, you can start the process of connecting with a lender using our simple online form.

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DISCLAIMER: While this guide offers a general overview to help small business owners identify the best formal structure for them, it is not intended as professional tax or legal advice. We strongly suggest consulting with a qualified tax professional and an attorney to create the best strategy for your unique circumstances.

Amy Fontinelle Finance Journalist

Amy Fontinelle is a writer, editor, and personal finance expert.

Her articles have appeared at Investopedia, Bankrate, MassMutual.com, The Simple Dollar, Interest.com, Yahoo, Forbes.com, SFGate.com, Bankaholic, Mortgage-Calc.com, Saving Advice and other sites.

Amy’s clients include personal finance websites, financial institutions, public policy organizations, academic journals, and professional economists.

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