C Versus S Corporation

In simplest terms, a C corporation is a standard business corporation. An S corporation is similar but has the benefit of avoiding double taxation.

Both C and S corporations are created by completing articles of incorporation, filing them with the proper state authority, and paying appropriate fees. Both are legal business entities that exist separately from their owners. The owners and shareholders are shielded from the company’s debts and obligations. If an owner dies or sells his interest, the corporation continues to exist unless it is formally dissolved. An advantage of corporations is that they can issue stock, the easiest way to attract outside investors.

The Key Difference Is Taxes

C corporations are taxed at both the corporate and individual level. That is, the corporation itself pays tax on business profits, and shareholders pay additional income tax for any money they draw from the corporation, including salary, dividends, or bonuses.

S corporations elect a special tax status with the Internal Revenue Service (IRS). Rather than being treated as a separate taxable entity, the S corporation’s income is viewed like that of a partnership or sole proprietorship and is "passed-through" to the shareholders, who report the income or loss on their individual tax returns. The S corporation itself pays no income tax.

Another tax advantage of S corporations is that they can distribute money as profits rather than salary to employees who are shareholders. Profits are not subject to the Social Security and Medicare taxes that salaries are. And when you sell an S corporation, the taxable gain on the sale of the business may be less than that of a C corporation.

Strict Requirements for S Corporations

S corporations offer many advantages, but the downside is their strict requirements. For example, each stockholder must be a U.S. citizen or permanent resident, and there can never be more than 75 stockholders. Only one class of stock can be issued—no preferred stock. Not all domestic general business corporations are eligible for S corporation status, such as banks, some insurance companies, and certain affiliated groups of corporations. There are other restrictions, as well.

S corporations (officially called Subchapter S corporations) are most appropriate for small business owners and entrepreneurs who want the legal protection of a corporation but want to be taxed as if they were sole proprietors or partners. Before deciding which sort of corporation to form, it is best to consult an attorney who specializes in corporate law.

A Good Valuation Is Essential

If you own a business, all your financial strategies depend on knowing what your company is worth. Owners often think they know, but in reality they may be shockingly misinformed. For example, SPARDATA, a leading national business appraisal firm, surveyed 2,000 business owners in 2001 and found that most misjudged the value of their businesses by 50% or more—sometimes by millions of dollars. So be sure your business is properly appraised before implementing any financial plan.