Alphabet Soup - C Corporations and S Corporations
Sounds tasty this time of year, until I tell you the title refers to trying to decide what form your business should take. C corp? S corp? LLC? GP? LP? PLLC? PC? Sole Prop? What’s a soup lover to do?
Although I am not qualified to specifically recommend any one of these to anyone, I do often to help people make sense of it all. It is important to keep in mind that it’s not so much the legal aspects that are important, it’s the accounting. Yeah, how the money flows and where, and the tax rules to which the particular form is subjected. What money, you say? We are currently saying the same thing. We hope that won’t be for long, though.
Now, let’s make sense of the letters in the soup:
I will start with the grandaddy of them all, the C corporation, or “C corp”. The “C” refers to a section of the federal tax code (remember, I indicated it’s the accounting that matters). When most people think of companies like General Electric, Microsoft, Ford, and their shareholders, they are thinking of C corps. The C corp is the traditional model–a company sells shares, is ruled by a board of directors, and has a bunch of officers (the President, chief executive officer, secretary, etc.) that are responsible for the day-to-day operations of the company. The C corporation structure allows you to assign shares and issue shares to shareholders. Each share is a piece of the company. Just like people, C corps pay taxes to local, state, and federal entities. Although it sounds complicated, one person can be sole shareholder, director and hold all of the officer positions.
States limit the number of shares that can be initially issued (in Washington States it’s 50,000), and who can own those shares. Accepting these restrictions means that you can remain private–you don’t have to file financial disclosure statements for all the world to see, you can choose the shareholders, and the shareholders don’t necessarily get to decide who runs the company.
If you want anyone, even other corporations, to be able to buy your shares, then it’s time to cough up the big bucks, file with the SEC, hold an initial public offering, and then be at the mercy of your shareholders for the rest of your days. It’s called “going public” and it’s a whole different ballgame. Visa recently went public.
Now for the accounting. Remember that I said C corps are like people? This means that C corps pay federal taxes on their earnings and everyone who gets paid by the corporation pays taxes on their earnings from the corporation. If you are the corporation’s sole shareholder and officer, then at tax time you will pay taxes on the C corp’s profits and taxes on wages, etc. the C corp paid you. In a way, it’s paying federal taxes twice on money earned once. This does not always hold true at the state level. Some states, such as Delaware and Nevada, do not have a corporate income or business tax. People love to set up corporations in these states.
Now for the C corp’s cousin, the S corp. Like the “C”, the “S” refers to a section of the federal tax code, not any legal designation. Unlike C corps, S corps cannot go public. They are limited to 100 shareholders, the shareholders cannot be other corporations, and the shares must be all one class.
Here’s what excites most people–S corps do not themselves pay federal taxes. Earnings, deductions and tax credits “flow through” to the shareholders, and the shareholders pay personal income taxes on their distribution share of the corporation’s earnings, regardless of whether any distributions were actually made to shareholders. In this way, S corps operate much like traditional partnerships.
So, if the tax end of things is disadvantageous, why would I form a corporation? Liability is one reason. If someone wants to sue the corporation, your personal asssets are protected. If the corporation owns your personal assets, however, they are corporate assets and can be collected against. Shareholders is another. If you want to sell shares in your company, or if you want to think about taking it public, you need to be a corporation that can issue shares.
This is a very simplified explanationof these two forms of business. As you can imagine, there are a great many other differences between the two, charitable deduction limits being one. To more fully understand the differences and to decide which one is right for you, I recommend a visit to a business attorney and/or accountant.
Next time: On to LLCs.
