C Corporation and S Corporation Differences
Federal Taxation
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. When the corporation chooses to pass along any of its after-tax profits to shareholders as 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.
Advantages of S Corporations in Handling Losses:
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S Corporations allow shareholders to offset other income by including their share of the corporation’s losses on their personal tax returns.
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However, shareholders cannot deduct corporate losses in excess of their “basis” in their stock — essentially their investment in the company with a few adjustments.
Additional Rule for S Corporations:
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No more than 25% of an S Corporation’s gross corporate income may come from passive income.
Employee Benefits
Both C Corporations and S Corporations can provide employee benefits that are deductible by the corporation and tax-free to the employees.
However, the tax-free status of some fringe benefits is less generous for S Corporation shareholders who own more than 2% of the corporation’s stock.
Capital Accumulation
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Since the corporate tax rate is typically lower than an individual’s tax rate, and profits retained in the corporation won’t be double taxed as dividends, a C Corporation can generally accumulate capital more effectively than an S Corporation.
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An S Corporation could accumulate capital by not distributing profits, but doing so might create problems for owners who would still have to pay income taxes.
Stock / Ownership
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S Corporation shareholders must be U.S. citizens or residents.
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C Corporations can have multiple classes of stock.
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S Corporations are limited to one class of stock (although voting rights can differ).
Business Activity Restrictions
S Corporations cannot conduct certain kinds of business. Ineligible businesses include:
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Banks
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Insurance companies taxed under Subchapter L
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Domestic International Sales Corporations (DISC)
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Certain affiliated groups of corporations
Corporation Size
Generally, C Corporations offer more flexibility and are better suited for large companies with many shareholders, especially those that are publicly traded.
Fiscal Year
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C Corporations can choose any fiscal year-end.
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S Corporations must use a December 31 fiscal year-end.
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If a C Corp with a non-December 31 year-end converts to an S Corp, it must switch to a December 31 fiscal year-end.
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If the S Corp status is later revoked, it cannot change from the 12/31 fiscal year.
Accounting Method
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C Corporations not considered small (gross receipts over $5,000,000) must use the accrual method.
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S Corporations must use the accrual method only if they have inventory.
Conversions Between C Corporation and S Corporation
Conversion from C Corp to S Corp
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A C Corporation can convert to an S Corporation anytime by filing Form 2553 with the IRS.
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Some states require an additional S election filing.
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After converting from an S Corp to a C Corp, the company must stay a C Corp for at least 5 years before converting back.
Conversion of an S Corp Back to a C Corp
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An S Corporation can convert back to a C Corporation anytime via a formal IRS request.
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The C Corp must retain the December 31 fiscal year and cannot reconvert to S Corp status for at least five years.
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Sometimes, forming a new C Corporation is more beneficial than converting back.
C Corporation and S Corporation Similarities
Entity
Both are legal entities treated as individuals under the law.
Creation
Both start as regular C Corporations through Articles or Certificate of Incorporation filed with the state.
Life
Both have unlimited life and continue after the death of owners.
Makeup
Both are structured with:
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Shareholders (owners)
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Directors (elected by shareholders to make major decisions)
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Officers (appointed by the board to manage day-to-day operations)
Frequently Asked Questions
What is the main tax difference between a C Corporation and an S Corporation?
A C Corporation pays corporate income tax separately from its owners, and any distributed dividends are taxed again at the shareholder level. This results in double taxation. In contrast, an S Corporation passes income directly to shareholders, who report it on their personal tax returns, avoiding corporate-level tax.
Can S Corporation shareholders deduct corporate losses?
Yes, shareholders of an S Corporation can deduct their share of the corporation’s losses on their personal tax returns, but only up to the amount of their basis in the company, which typically includes their investment and certain adjustments.
Why might a business choose a C Corporation for capital accumulation?
C Corporations generally retain profits more efficiently since retained earnings are taxed at the corporate rate and not immediately taxed to shareholders. This allows for more effective capital accumulation, especially for growing or reinvesting businesses.
Are there ownership restrictions for S Corporations?
Yes, S Corporation shareholders must be U.S. citizens or residents, and the corporation is limited to one class of stock, though it may have different voting rights. C Corporations can have multiple classes of stock and no citizenship restrictions.
How does the fiscal year differ between C and S Corporations?
C Corporations can choose any fiscal year-end, while S Corporations must use a December 31 year-end. If a C Corp converts to an S Corp, it must switch to a calendar fiscal year and cannot change it unless S status is revoked.