Creating a business entity for your business, such as a corporation or limited liability company, offers a wide variety of benefits. State law governs the formation and governance of these organizations, while federal law governs the aspects that relate to federal income taxes. The Internal Revenue Code (IRC) recognizes two types of corporations: “C” corporations and “S” corporations. Choosing the form that is right for your business depends on multiple factors, including the existing structure of your business and your goals with regard to matters like financing and growth.
What Is a Corporation?
The primary purposes of a corporation are to allow the owners of a business to operate it as a single legal entity, while also protecting those owners from various forms of liability. A corporation has the authority to enter into contracts and conduct other activities in the same way that real human beings can.
The owners of a corporation are known as shareholders. Their ownership is represented by shares in the corporation, also known as stock. Shareholders are nominally in charge of running a corporation, but they usually delegate this duty by electing a board of directors. The directors further delegate operations to officers, such as a CEO or president, a treasurer, and others. Shareholders may receive a portion of a corporation’s profits in the form of dividends.
The default tax treatment of a corporation is known as “C corporation” status, based on Subtitle A, Chapter 1, Subchapter C of the IRC. Perhaps the most well-known feature of a C corporation is the “double taxation” of dividends. The corporation pays federal income tax on its revenue. Should it pay all or part of its profit to the shareholders as dividends, the shareholders will pay federal tax on that income. The same money is therefore taxed twice.
S corporations, as discussed below, offer an alternative to double taxation, but it comes at the cost of restrictions on ownership. The IRC places no specific ownership restrictions on C corporations, meaning that almost anyone—individuals, other corporations, other business entities, trusts, etc.—can be a shareholder, with no numerical limit.
C corporations can create different classes of stock in addition to common stock, such as preferred stock at one or more levels. This is a common feature with companies seeking venture capital financing. Sticking with C corporation status may be preferable for companies that want to grow, and for shareholders who might want to sell the business some day.
By filing a form with the IRS, shareholders can elect subchapter S status. This means that while the corporation must still file a tax return, it does not directly pay federal income tax. Instead, the corporation is subject to “pass-through taxation,” similar to a partnership. The shareholders report a pro rata share of the corporation’s profits or losses on their own tax returns, and they pay the tax on that amount. The money is therefore only taxed once.
S corporations are limited to 100 shareholders, who must be U.S. citizens or lawful permanent residents. Other corporations cannot be shareholders in an S corporation, nor can limited liability companies, partnerships, or various trusts. An S corporation can have only one class of stock. This limits a corporation’s flexibility, but it can be beneficial for smaller corporations that want to keep their operations close to home.
If you have questions about whether to form a C or S corporation in California, the Enterprise Consultants Group’s tax advisors can help you understand your options. You can contact us today online or at (800) 575-9284 to discuss your case.