Many people are confused as to exactly when a regular corporation (C Corporation) becomes an S Corporation. It is commonly thought the S Corporation election is made at the time the corporation is originally formed. That is not correct.
When you form a corporation, you’ll want to know how and when a C Corporation becomes an S Corporation as well as the differences between the two. And you should also be aware of certain restrictions that apply to an S Corporation but not a C Corporation. This guide walks you through a comparison of these two types of corporations in plain language. We recommend you discuss your specific situation with your attorney, accountant or tax advisor when choosing between C Corporation and S Corporation status.
When a corporation is originally chartered by the state, it exists as a C Corporation. If you do nothing more after forming your corporation, it will remain a C Corporation. A C Corporation becomes an S Corporation only when, with the consent of all shareholders, special tax treatment (“pass-through taxation”) is sought by filing Form 2553 with the IRS in accordance with Subchapter S of the Internal Revenue Code.
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The S Corporation election can be filed anytime after the corporation is formed – immediately, or years later.
When you make a valid S election with the IRS for federal income tax purposes, most states will also honor that federal S election for state purposes. However, a few states require that you also file an S Corporation election with the state and some states do not extend the same S Corporation tax exemptions. You will want to find out exactly how the state in which your corporation will operate treats S Corporations.
You should also know that an S Corporation can convert back to a C Corporation by filing a formal request with the IRS - but the C Corporation must keep the December 31 fiscal year (required for S Corps) and it cannot later convert back to an S Corporation for at least five years.
Identifying the most beneficial tax treatment for your specific situation is very important - it can pay dividends for years to come. So delaying your S Corporation election decision will give you time for further consideration as well as an opportunity to consult with your attorney, accountant or tax advisor.
Your corporation can continue as a C Corp for as long as you like. Preparation of Form 2553 (which you must file with the IRS) is the only additional step MaxFilings performs when you select “S Corp” as part of the online incorporation process, and preparing Form 2553 has no effect until you complete it and then file it with the IRS.
Read on to learn more details about the differences between C and S Corporations.
A C Corporation is taxed as a separate entity and must report profits and losses on a corporate tax return. The C Corp pays corporate taxes on its profits while the shareholders are not taxed on the corporation’s profits. C Corp shareholders report and pay income taxes only on what they are paid by the corporation. Now when the corporation chooses to pass along any of its after-tax profits to shareholders in the form of dividends, the shareholders must report those dividends as income on their personal tax returns even though the corporation has already paid corporate taxes. This is commonly referred to as “double taxation”, something that is avoided with an S Corporation (a pass-through tax entity).
While an S Corporation with more than one shareholder does file an informational K-1 tax return, the corporation itself does not pay any income taxes. Instead, the individual shareholders (owners) must include their share of the corporation’s profits on their personal tax returns, paying tax at their individual tax rate.
S Corporations provide another advantage should the corporation experience losses. Unlike C Corporation shareholders, S Corp shareholders are allowed to offset other income by including their share of the corporation’s losses on their personal tax returns provided, however, they cannot deduct corporate losses in excess of their "basis" in their stock – that being the amount of their investment in the company, with a few adjustments.
Keep in mind that no more than 25% of an S Corporation’s gross corporate income may be derived from passive income.
While states generally treat S Corporations the same way the federal government treats S Corporations, there are exceptions.
Some states simply do not recognize S Corporations. You can still have an S Corporation in the state and enjoy the federal tax savings but the S Corporation is an S Corporation for federal tax purposes only - not for state tax purposes, where the corporation will be treated as a regular C Corporation.
A few states tax both the S Corporation's profits as well as the shareholders’ proportional shares of the S corporation's profits. In such states, the S corporation is double-taxed in a manner similar to a C Corporation that paid all of its profits as dividends.
Other states tax S Corporations on only part of their income even though they do recognize the S Corporation.
And there are other ways some states tax S Corporations. With so many variations, you will want to avoid any surprises. Prior to electing to become an S Corporation, find out exactly how the state in which the corporation will operate treats S Corporations. Consult with your tax advisor or contact the state income tax agency to determine whether a separate S Corporation election form is required for the state and what, if any, state taxes apply to S Corporations.
Compensation of Officers
The IRS requires that owner-employees of an S Corporation be paid wages and that the salary paid an owner-employee be a “reasonable amount” for the work being performed. Of course that means employee-owners cannot avoid paying payroll taxes by paying themselves nothing. And their salaries will be subject to payroll taxes, even if the corporation is losing money.
While both C Corporations and S Corporations are allowed to provide employee benefits that are deductible by the corporation and tax-free to the employees, the tax-free status of some fringe benefits is not nearly as generous for S Corporation shareholders who own more than 2% of the corporation’s stock.
Since the corporate tax rate is typically lower than an individual’s tax rate and profits retained in the corporation will not be double taxed as dividends, a C Corporation can generally accumulate capital more effectively than an S Corporation. Of course an S Corporation could accumulate even more capital if it did not distribute any of its profits to the shareholders – but doing so would create obvious problems for some owners who would have to pay income taxes on this “phantom income” which they did not actually receive.
Each S Corporation shareholder must be a U.S. citizen or resident. C Corporations can have multiple classes of stock while S Corporations are limited to one class of stock (voting rights can differ).
S Corporations are not allowed to conduct certain kinds of business. Business corporations that are not eligible for S Corp status include banks, insurance companies taxed under Subchapter L, Domestic International Sales Corporations (DISC), and certain affiliated groups of corporations.
Generally speaking, C Corporations offer more flexibility than S Corporations and are therefore the best choice for large companies with a large numbers of shareholders, especially if they are publicly traded.
C Corporations can choose when their fiscal year ends while an S Corporation’s fiscal year end must be December 31. If a C Corp has been using a fiscal year end other than December 31, it must change to a December 31 fiscal year end if it converts to an S Corp. And if the S Corp status is later revoked, it cannot change from the 12/31 fiscal year.
C Corporations not considered a small corporation ($5,000,000 or less in gross receipts) are required to use the accrual method of accounting while only those S Corporations that have inventory must use the accrual method of accounting.
Conversion from C Corp to S Corp
A C Corporation can make its original conversion to an S Corporation at any time after being originally formed by filing a Form 2553 with the IRS. A few states require that an S election also be filed with the state. In cases where a C Corp is converted from an S Corp, it must remain a C Corp for at least 5 years before it can be converted back to an S Corp.
Conversion of an S Corp back to a C Corp
An S Corporation can convert back to a C Corporation anytime by filing a formal request with the IRS. However, the C Corp must keep the December 31 fiscal year and it cannot convert back to an S Corp for at least five years (restrictions that hamper the ability to save taxes by shifting income between taxable years, a strategy practiced by some). It can sometimes be more beneficial to form a brand new C Corporation rather than converting.
Both C Corporations and S Corporations are legal entities and treated as individuals under the law.
Both C Corporations and S Corporations are initially the same, regular corporations (C Corporations) created by officially filing what is normally called Articles of Incorporation or a Certificate of Incorporation with a state.
Both C Corporations and S Corporations have unlimited life, continuing to exist after the death of owners.
Both C Corporations and S Corporations are made up of shareholders who are owners of the corporation, directors (elected by the shareholders) who make major management decisions, and officers (elected or appointed by the board of directors) who are responsible for the day to day operations of the corporation.
Both C Corporations and S Corporations provide limited liability protection for shareholders (owners) who cannot normally be held responsible for the corporation’s obligations.
Both C Corporation and S Corporation ownership is transferred by selling shares of the corporation’s stock.
Both C Corporations and S Corporations can raise additional capital by selling stock
Both C Corporations and S Corporations are allowed to provide employee benefits that are deductible by the corporation and tax free to the employees. Retirement Plans, Medical Plans, Life Insurance, Childcare, and Education Plans are some of the types of benefits frequently offered. While the rules vary for the plans, the tax-free status of some is not nearly as generous for owners with more than 2% of an S Corporation’s stock.
Personal Income Taxes
Both C Corporation and S Corporation shareholders (owners) must pay personal income tax on any salary drawn from the corporation as well as any dividends paid or earnings that are distributed.
Both C Corporations and S Corporations must comply with state requirements regarding the organization and operation of corporations. That would include the adoption of bylaws, issuing stock and maintaining shareholder records, holding and recording the minutes of meetings of shareholders and the board of directors, and preparation and filing of all required state and federal reports. It is very important that all required procedures are followed since courts can find that a corporation’s principals have not operated the business as though it is a corporation and are therefore not entitled to the limited liability protection they would otherwise have. In such cases, courts may “pierce the corporate veil” and hold a corporation’s principals personally liable for what would otherwise be a liability of the corporation.
We hope you find this information useful as you determine whether a C Corporation or S Corporation is best for you. We’d also like to remind you to consult with your attorney, accountant or tax advisor. We cannot guarantee that all of the information above is accurate, complete and/or current, and it should therefore be independently verified.
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