Back when I practiced law, I once had a very challenging client.
You know the type.
This particular client — let’s call him Johnny — refused to take my advice (indeed, why he hired me still remains a mystery). He owned a shop that bought, refurbished, and sold used computer equipment and peripherals. Johnny’s first mistake was that, despite my warnings, he never separated his personal and business assets. His personal checking account doubled as his business checking account. Worse, he never incorporated, despite my pleas to the contrary. He remained a sole proprietorship.
You know how the story ends, right? Of course right.
One day, one of his used computers crashed and a corporate client of his lost a lot of data – and money – as a result. The client eventually sued, and because Johnny was unincorporated, and because he co-mingled personal and business finances, his personal assets were on the line.
In the end, Johnny lost the case, lost his business too, and then filed for bankruptcy.
A $1,000 Steve incorporation special, or even a simple $100 DIY incorporation would have eliminated that possibility because it would have changed his legal entity type to a corporation, which would have given him, among other things, liability protection.
So the question is not – ‘should you incorporate?’ because the answer to that is obvious; that is Small Business 101. Rather, the question is ‘what type of corporation is best for your small business?’
Let’s answer that (but only on the condition that unlike a former client of mine, you promise to listen)!
The beautiful thing about a corporation is that it is a stand-alone, unique legal entity, separate and apart from you personally. As such, it creates what is known as the “corporate shield,” and if that sounds like something out of the Marvel universe, well, it sort of is, at least legally speaking.
If you own a business sans incorporating, like my old pal Johnny (e.g., you are legally structured as a sole proprietor, a freelancer, or a partnership), you personally are on the hook for any and all business debts and liabilities. Your home, your assets, your bank account – everything – is at risk.
Incorporating creates a “bright line” between you and your business. You are you, your business is your business, and (almost) never the twain shall meet. If you negligently refurbished a computer causing a client to lose her entire customer list, it is your business that would be on the hook, not you.
And that, my friends, is the power of the corporate shield. It is a legal force field that protects you. Aside from personal protection, corporations – either S or C – have a few other things in common:
- Formalities. Because they are in fact unique legal entities that can sue and get sued, all corporations must meet certain legal requirements, formalities, and so on. Articles of incorporations must be filed for creation, bylaws must be agreed to and filed with the state, annual shareholder and director meetings must be held, stock must be issued, fees paid, tax laws must be adhered to, and so on.
- Execution: Shareholders of both types of corporations are the owners, but they don’t make the decisions. The board, officers, and CEO, COO, CFO are the ones who run the business day-to-day.
- Formation: Both S and C corps are begun by filing “articles of incorporation” and a set of by-laws with the Secretary of State of the state in which the entrepreneur chooses to incorporate.
That said, there are several different types of corporations. There are professional corporations, non-profit corporations, S corporations, C corporations, limited liability companies, and more. Some people even consider LLCs (Limited Liability Companies) a form of corporation. So the question is – which is right for you?
So, which is best for your business, S or C? Let’s see, but here’s a spoiler alert! For a variety of reasons, entrepreneurs and small business people usually choose to go the S corp route. Let’s see why.
S Corps: Advantages and Disadvantages
According to Investopedia,
An S corporation, also known as an S subchapter, refers to a type of corporation that meets specific Internal Revenue Code requirements. If it does, it may pass income . . . directly to shareholders, without having to pay federal corporate taxes. Usually associated with small businesses (100 or fewer shareholders), S corp status effectively gives a business the regular benefits of incorporation while enjoying the tax-exempt privileges of a partnership.
Pros of S Corps
There are several reasons why S corps are the preferred legal structure for many small businesses.
1. Ease of Taxes
This is a big reason, maybe the biggest reason, that entrepreneurs choose S over C. S corp taxes are less and easier to file compared to taxes with C corporations.
S corporations are what are known as "pass-through" entities in the internal revenue code. S corps are taxed this way:
The corporation itself does not pay any taxes. Instead, whatever profit the company makes passes through onto the owners’ personal income taxes and taxes are paid there. Thus, for example, say that you are a small business owner with an S corp that you own by yourself (you are the only shareholder) and it made $100,000 last year. That $100,00 would flow-through onto your own personal tax returns and you would pay tax on that using an IRS Form 1120S at your personal rate (there is no corporate rate for S corps).
2. Tax Deductions
Until 2025, owners of S corps can deduct 20 percent of business income from their tax returns. This 20 percent business tax deduction is not a little thing. Being able to deduct up to 20 percent of business income can net a big savings.
3. Startup Tax Benefits
The early years of a business may show losses before it starts to turn a profit. Fortunately, with an S corp, those operating losses can be written off on the owner’s personal income tax return because the company’s finances flow-through to the owner.
4. No Double Taxation
This is the big one. C corps are taxed twice.
We no likey.
The first time a C corp is taxed is on the corporate level, when the owners file a corporate tax return, Form 1120. The second time is when any dividends are made to shareholders. In that case, those payments are considered income to the individuals and so that corporate money is taxed a second time.
This so-called “double-taxation whammy” is of course very unattractive to entrepreneurs and is a main reason they only choose a C corp legal structure if they have to (i.e. their business model relies on them going public someday).
Other S Advantages
- S corp owners can write off business losses in their personal income taxes. C corp owners cannot.
- It is easier to deal only with personal taxes, as opposed to personal and corporate taxes for the C situation.
- There are a smaller number of shareholders with an S corp. The max is 100. This also means that there will be no outside strangers taking over.
- In an S corp, all stock is the same – it’s therefore more egalitarian
Cons of an S Corporation
Truly, there are not many downsides to an S corp for the small business. If there is, it has to do with the limits of the structure upon growth.
1. Shareholder Limits
Because S corps are limited to no more than 100 shareholders, if you struck gold and suddenly wanted or needed to go public, you'd be in a bit of a bind. A public company, of course, needs unlimited shares. That's the advantage of a C corp. S corps are limited in growth that way.
2. Potential Financial Limits
The other possible downside is that the type of shareholder an S corp can have is limited, and again, that may limit growth. As indicated, S corporations limit the number of shareholders to no more than 100. Moreover, they must either be U.S. citizens or resident aliens. Other corporations, business entities, LLCs, partnerships, and trusts cannot be owners of an S corp. As such, raising money from outsiders is more difficult.
C Corporations Advantages and Disadvantages
According to Investopedia,
A C corporation (or C-corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation. The taxing of profits from the business is at both corporate and personal levels, creating a double taxation situation.
Pros of C Corps
There are some very specific reasons to choose a C corp over an S corp as a legal structure.
1. Ability to Scale
If you are looking to create a company that you hope will go public someday, then this alone is reason to choose a C corp as your legal structure. Jeff Bezos, when he first set up Amazon in his garage in Seattle those many moons ago, started as a C corp. His vision, even then, was BIG.
The reason is that with a C corporation, there are no limits on ownership. You can have an unlimited number of shareholders and different classes of stock. Also, with a C corp, any number and type of entities or business structures can be stockholders:
- Foreign individuals
- Angel investors
- Venture capital firms
- Other corporations
In addition, preferred stock (meaning, stock that gets paid back prior to other common shares) can only be issued by C corporations. S corps can only have one class of stock.
2. Raising Capital
C corps can issue various classes of stock, making that stock more desirable. Furthermore, given the company may go public, shares are more fungible and easier to buy and sell. Further, that the company may potentially go public is a nice inducement for angel investors.
C Corporations can also continue to print, sell, or otherwise distribute more and more shares. Yes, that can devalue the overall shares, but still, being able to have unlimited shares and shareholders means continued growth (hopefully!).
3. Tax Benefits
While taxes are rarely listed as a “pro” of C corps, these days at least the corporate tax rate must be considered a benefit. How much is the corporate tax rate, you ask? Well, thanks to the Trump tax cut, C corporations are taxed at a flat 21 percent.
Additionally, fringe benefits are not taxable to C corps. Also, C corps are the only business type that can give to charity and deduct the cost of that donation up to 100 percent, so they got that going for them.
Cons of C Corps
1. Double Taxation Whammy
The biggest downside to having a C corp can be summarized in one sentence: C corps are taxed twice. Again, they are first taxed at the corporate level on profits. Then, when dividends are paid to shareholders, they are taxed again.
2. Not a Good Small Business Fit
There is also the fact that C corps are simply designed for bigger businesses, or at least companies that want to become bigger businesses. Unlimited shareholders and shares, corporate taxes and more — it’s all far more complicated in the C world. As such, C corps are usually not a good fit for small businesses. We don’t need all that formality and all of those unknown shareholders.
Given all this tax talk, it might behoove us to examine a hypothetical to see how the difference in taxation could affect each type of business. Let’s say your business made that $100,000. As a C corp, it would get taxed 21 percent, or $21,000. The remaining $79,000 would likely be distributed as a dividend and therefore would be subject to the dividend rate of 15 percent, or $11,850. Total taxes as a C corp = $32,850.
With an S corporation, that same $100,000 would flow through to your personal returns, putting you in the 24 percent bracket. Thanks to the Tax Cuts and Jobs Act passed in 2018, small businesses can deduct 20 percent of their business’ income from their net income. That would put your net income at $80,000 and your taxes would then be 24 percent of that, which is $19,200 — as opposed to more than $32,000 for the same entity as a C corp.
So again, we see the advantage of the S for the small biz.
As you can see, while both types of legal entities have their pros and cons, it’s pretty easy to appreciate why the S corp is favored. Between a simpler and more beneficial tax structure, as well as a less complicated operating and ownership model, the S corporation is usually the way to go.
(Unless, of course, you would rather do nothing at all and get sued into oblivion!)