In recent years, changes in tax laws have affected the way small businesses elect to be taxed. Businesses typically form corporations when transitioning from a sole proprietorship to a larger entity with multiple owners or employees. However, now businesses are more likely to be formed as limited liability companies.
Owners of corporations eligible to elect S status either must make an affirmative election or remain a C corporation. According to Forbes contributor Robert W. Wood, C corporations are the default status of all corporations. Although C corporations are the most common type of corporation in the U.S. according to Incorporate.com, the S corporation status may be more beneficial.
Deciding between the S- and C-corp
"...the main distinction between the two is that they are taxed very differently."
Many corporations are C corporations for tax purposes because they fail to satisfy certain technical requirements rendering them ineligible to elect S status. Both S and C corporations are entitled to limited liability protection, are owned by shareholders and are governed by a Board of Directors. Each corporation is designated as a separate legal entity and these concepts are familiar to most business owners. However, the main distinction between the two is that they are taxed very differently.
With an S corporation election, businesses receive the benefits of being taxed on a pass-through basis similar to a partnership or a limited liability company taxed as a partnership. S corporations are not taxed on its income; instead, that income is taxed to the shareholders.
The income of a C corporations is taxed twice – once at the entity level where net income is subject to corporate tax rates and a second time at the shareholder level when dividend distributions are made. An S corporation must make distributions with respect to stock that are in proportion to each shareholder’s ownership percentage. When compared to an S corporation, a partnership or LLC offers more flexibility in structuring different economic, managerial and voting arrangements among the participants.
"...companies converting from C to S could be subject to additional corporate taxes..."
There is a difference between a C corporation and an S corporation with respect to fringe benefits as S corporations are subject to the more restrictive and less generous partnership rules. A company could elect to be a C corporation for a while, then switch its status to that of an S corporation. It is also important to consider that companies converting from C to S could be subject to additional corporate taxes if it sells assets within five years of making theS election. This rule is designed to prevent a switch just prior to sale of the underlying business and it has thwarted many a retirement plan.
Many accountants favor S corporations because one-half of the self-employment taxes are paid by the corporation and dividend distributions escape self-employment tax, provided a reasonable salary is being paid to a shareholder who works for the S corporation. S corporations do not have individual capital accounts for each shareholder which simplifies matters.
S corporation eligibility
The S corporation election may be beneficial for a small business because it allows a company to have up to 100 shareholders in a calendar year. The shareholder rules are also favorable because it allows for U.S. citizens, resident aliens and qualifying trusts, which opens up share ownership to a wide audience. Non-residents are not eligible and not all trusts are eligible to own S stock.
When an S corporation acquires stock of another S corporation (target) it must make a special election to treat the target as a division. C corporations cannot own stock of an S corporation. Provided distributions on stock remain pro rata, S corporations may offer stock with different voting rights. This feature enables small businesses to differentiate voting influence based on share ownership, but it is not as flexible as a limited liability company.
"...the S corporation may be better suited to the needs of small businesses..."
Both the C corporation and S corporation are similar corporate models, and both have their advantages. However, the S corporation may be better suited to the needs of small businesses, specifically because of one level of taxation on operating income and upon sale of the business.
The tax implications cannot be overstated because in the event that the business assets are sold, C corporations are taxed on proceeds of the sale and the shareholders are taxed again on the distribution. As S corporations are only taxed once at the shareholder level on a sale of assets, it is more tax efficient. Although a sale of S or C stock results in only one level of taxation and that is at the shareholder level, buyers are reluctant to purchase stock and assume the liabilities inherent in an existing corporation.