Deciding Upon C-Corporation Or S-Corporation Tax Status
So you're trying to decide if a C-Corporation or an S-Corporation
tax structure is better for you? As discussed in
How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners, here are some factors to consider:
1. Do you plan to remove most of the profit from the corporation? Are there significant profits above what might be considered a
reasonable salary for you as President and CEO?
If so, you might
favor an S-corporation, because S-corporations are pass-through tax
devices. For S-corporations, there is generally no tax at the corporate
level. This means that once a reasonable wage is paid, excess
profit can be removed as distributions. Had you chosen a C-corporation,
dividends are doubly-taxed.
2. Wages for the owner/employees can also withdraw money form
So, if the expected profit you wish to remove is
comparable to a reasonable wage, you might be OK with either a
C-Corporation or an S-Corporation. Wages greatly in excess of
reasonable salaries may be challenged by the IRS, who may view
the wages as dividends in disguise. (As I mention in How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners, in some industries, a $4 million salary for the CEO of a moderate-size corporation might be deemed acceptable. And, sometimes, you can actually win against the IRS in tax court even if your salary is challenged. But, the experience probably wouldn't be fun.)
Salary is subject to about a 15% employment tax, but you do get more future Social Security benefit by paying more in employment tax. And, many retirement plan maximums are also based upon salary level. This somewhat offsets the negative of paying higher employment taxes. Many entrepreneurs choose S-corporations over LLCs, C-corporations, sole proprietorships, and partnerships to minimize employment taxes on wages. For many entrepreneurs, this is a multi-million dollar decision. If you plan to remove large amounts of cash from a profitable company and you feel the amounts are larger than a reasonable wage, consider the S-Corporation. (This topic is covered at length in How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners.)
3. Do you plan to grow your business?
If you plan to retain most of the income for corporate growth, either S-Corporations and C-Corporations can work well. A C-corporation is probably preferable if you plan to offer employee stock options, which could be classified as a second class of stock (an S-corporation IRS no-no). I discuss offering employee stock options in more detail in How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners. S-corporation shareholders can also face phantom income, but that is easily remedied by paying small distributions to shareholders to offset individual tax liability. (You'll want to check with your business attorney for more information about stock options.)
4. Do you have high-income investors, and do you anticipate losing money for the first few years?
If so, S-corporation losses pass through to the investors who can offset their other taxable income. This is fully allowed. As discussed How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners, the IRS isn't keen on tax shelters where losses exceeding an investor's original investment in a company are passed through, as some tax schemes in the past tried to achieve. If such losses in excess of "basis" were allowed, an investor could "buy" tax deductions. That isn't allowed. This is why entrepreneurs need a basic understanding of stock basis and passive losses, as mentioned in How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners.
5. Is there some reason the IRS will not allow your company to use the S-corporation structure?
For example, maybe you have certain non-people shareholders, such as certain trusts, the IRS forbids to own S-corporation shares. Or, there may be too many shareholders as allowed for S-corporation status. (Too many shareholders should be quite rare for the typical small corporation, which typically only has a few shareholders. Some trusts can own S-corporation shares.)
If you plan to use SCOR (Small Corporate Offering Registration) to raise funding for your corporation, you'll probably become a C-corporation. And, public companies are C-corporations.
Most corporations have annual revenues of less than $5 million per year. And, many corporate owners remove substantial profits from their companies. For these companies, the S-corporation structure works well.
Peter Hupalo, author of
How to Start And Run Your Own Corporation: S-Corporations For Small Business Owners