While both S-Corporations and C-Corporations can be beneficial for startups, they have distinct advantages and disadvantages in terms of ownership, taxation, dividend distributions and raising capital. Startups must carefully consider these factors and consult with experienced advisors before deciding which type of corporation is right for their business.
These general principles will help you understand which entity type is the best fit for your startup’s unique needs. But remember, every situation is unique, so it’s best to work with your tax advisor and legal counsel to make your final decision. If you’re looking for counsel, feel free to reach out to us here.
Tax Implications of S-Corps vs C-Corps
S-Corps and C-Corps have distinct methods of taxation. Both types of corporations pay federal income tax, but the way in which they are taxed is different.
C-Corporations are subject to double taxation, which means that the corporation’s profits are taxed first at the corporate level and then again at the individual level when those profits are distributed as dividends to shareholders. This can result in a higher overall tax burden for C-Corporations compared to S-Corporations.
S-Corporations are pass-through entities, which means that the corporation itself does not pay federal income tax. Instead, profits and losses are passed through to shareholders who report this information on their personal income tax returns. This can result in lower overall taxes for S-Corporation shareholders.
Not all businesses are eligible for S-Corp status either. To elect S-Corp status, a corporation must meet certain criteria established by the IRS, including having no more than 100 shareholders, limiting shareholders to U.S. citizens and only one class of stock.
The decision between an S-Corp and a C-Corp depends on many factors beyond just tax implications. Startups must consult with a qualified attorney or accountant before making a decision about which type of corporation is right for their business. If you’re looking for legal counsel, feel free to reach out to us here.
Ownership of S-Corps vs C-Corps
Beyond tax implications, there are differences in the ownership and management structures of S-Corporations and C-Corporations.
C-Corporations allow an unlimited number of shareholders, including individuals and other corporations, to buy and sell shares freely. This makes it easier for C-Corporations to raise capital and eventually IPO.
On the other hand, S-Corporations are limited to a maximum of 100 shareholders, all of whom must be U.S. citizens or residents. Additionally, only one class of stock is allowed in an S-Corp, meaning that all shareholders must receive equal distributions of profits.
When deciding between an S-Corp or a C-Corp, startups must consider not only the tax implications but also the ownership and management structures that best suit their business requirements.
Incorporating as an S-Corp or C-Corp
Incorporating as an S-Corp or C-Corp involves similar processes with some key differences.
To incorporate as a C-Corporation or an S-Corp, the business must file articles of incorporation / certificate of incorporation with the state it desires to incorporate in. These articles typically include basic information about the company such as its name, address, purpose, authorized shares and par value of shares. They may also provide details about its ownership structure and management.
After the articles of incorporation are filed and approved, the startup will issue shares to the founders, hold an organizational meeting to elect a board of directors and adopt bylaws. Bylaws outline how the corporation will be run and provide guidelines for decision-making. The board of directors is responsible for making major decisions on behalf of the corporation.
So far, so good. Now here’s where the processes differentiate.
In order to become an S-Corp, there is one additional step. The startup needs to elect S-Corp status with the IRS by filing Form 2553 after filing articles of incorporation with the state. This form must be filed within 75 days of incorporating or within 75 days from the start of the tax year in which S-Corp status is desired.
It’s important to note that S-Corporation status can only be elected if certain criteria are met, including having no more than 100 shareholders and only one class of stock.
Investor Perspective: S-Corps vs C-Corps
Investors may view S-Corporations and C-Corporations differently.
C-Corporations can offer different classes of stock, providing greater flexibility in investment structure. Additionally, their susceptibility to double taxation means they may have more cash on hand for reinvestment or distribution to shareholders, making them more attractive to investors.
However, S-Corporations are much less appealing to investors. In general, venture capital firms will only invest in C-Corps.
Startups should understand how their choice of corporation structure may affect potential investment opportunities and consult with experienced advisors before making a decision.
Shareholder Limitations for S-Corps and C-Corps
S-Corporations can have no more than 100 shareholders, all of whom must be U.S. citizens or residents. In addition, only one class of stock is allowed, which means that all shareholders have the same rights and privileges.
C-Corporations, on the other hand, can have as many shareholders as they want with no restrictions on their citizenship or residency status. Additionally, C-Corporations can issue different classes of stock with varying voting rights and dividend preferences.
Startups should consider these limitations when deciding which type of corporation structure is best suited for their business needs. For example, if a business plans to raise capital through multiple rounds of funding from many investors, a C-Corp may be the better choice because of its flexibility in issuing different classes of stock. However, if a business has a small group of owners who want equal say in decision-making and distribution of profits, an S-Corp may be more appropriate.
Dividend Distributions in S-Corps vs C-Corps
S-Corporations and C-Corporations differ in how they distribute dividends to shareholders.
C-Corporations offer more flexibility in terms of dividends. They can issue different classes of stock with varying dividend preferences, allowing some shareholders to receive priority distribution of dividends over others. Additionally, C-Corporations can choose to retain earnings and reinvest them in the business instead of distributing them as dividends.
In contrast, S-Corporations must distribute profits to shareholders based on their percentage of ownership. This means that all shareholders must receive equal distributions of profits regardless of their investment or role within the company.
While this may seem like a disadvantage for S-Corps, it can also be seen as an advantage as it promotes equality among shareholders and ensures that everyone benefits equally from the company’s success. Moreover, since S-Corp profits are only taxed once at the individual level, shareholders may still have a lower overall tax burden even if they receive equal distributions of profits.
Choosing between an S-Corp and a C-Corp will depend on various factors beyond just dividend distributions. Startups should consult a qualified attorney or accountant before deciding which type of corporation will work best for their business.
Maintaining S-Corp Status
To maintain S-Corp status, certain requirements must be met. These include:
- Having no more than 100 shareholders, all of whom must be U.S. citizens or residents. If the number of shareholders exceeds 100 or if a shareholder who is not a U.S. citizen or resident is added, the corporation will lose its S-Corp status.
- Issuing only one class of stock. This means that all shareholders must receive equal distributions of profits and have equal voting rights. If multiple classes of stock are issued or if any shareholder receives preferential treatment in terms of dividends or voting rights, the corporation will lose its S-Corp status.
- Filing an annual tax return on Form 1120S with the IRS. This form reports the corporation’s income, deductions and other relevant financial information for the year.
Startups considering S-Corp status should understand these requirements and ensure that they are able to meet them in order to maintain their tax benefits and avoid losing their status as an S-Corporation.
Converting from an S-Corp to a C-Corp or Vice Versa
Converting from an S-Corporation to a C-Corporation or vice versa can significantly affect taxes for startups.
If a corporation converts from an S-Corp to a C-Corp, its profits will be subject to double taxation. This means that the corporation will pay taxes on its earnings at the corporate level, and the shareholders will be taxed again on their individual tax returns when they receive dividends or sell their shares. Furthermore, the conversion may trigger capital gains taxes if the value of the corporation’s assets has increased since it was first formed as an S-Corp.
On the other hand, if a corporation converts from a C-Corp to an S-Corp, both the corporation and its shareholders can save a significant amount of taxes. S-Corps are pass-through entities, which means that profits are only taxed once at the individual level rather than both at the corporate and individual levels. This can result in lower overall taxes for shareholders and allow more cash to be reinvested in the business.
Startups considering changing their corporation structure should carefully consider these tax implications and seek guidance from experienced advisors before making any decisions.
In conclusion, choosing between an S-Corp and a C-Corp involves weighing the pros and cons of each entity type, including tax implications, ownership and management structures, shareholder limitations, dividend distributions, and potential investment opportunities. Startups must carefully consider these factors and consult with experienced advisors before deciding which type of corporation is right for their business. It’s important to remember that every situation is unique, and that working with a tax advisor and legal counsel is critical to making the best decision for your business.
