The difference between a C-Corporation and an S-Corporation is in the way each is taxed. Under the law, a corporation is considered to be an artificial person. Shareholders who work for the corporation are employees; they are not “self-employed” as far as the tax authorities are concerned.
In theory, before a C-corporation distributes profits to shareholders, it must pay tax on the income, at the corporate rate. Then, leftover profits are distributed to the shareholders as dividends, which are then treated as investment income and taxed to the shareholder. This is the “double taxation” you may have heard about. In reality, most (if not all) of a small C-Corporation’s earnings are paid out to its employees as wages, bonuses, fringe benefits, etc. Often, there is no “income” for the small C-Corporation to owe tax on, unless the shareholders choose to keep taxable earnings in the company to reinvest for future growth. Should you choose to keep profits in the corporation and pay tax on that income, it will be taxed at the corporate tax rate, which is typically lower than the individual tax rate the shareholders are subject to.
C-Corporations enjoy many tax-related advantages :
- Income splitting is the division of income between the corporation and its shareholders in a way that lowers overall taxes. By working with an experienced tax advisor, you can determine exactly how much money the corporation should pay you, as an employee, to ensure the lowest tax bill at the end of the year.
- C-Corporations enjoy the greatest variety of tax-favored fringe benefits of any business entity. Fringe benefits may include things like health insurance, retirement accounts, and medical reimbursement plans.
- With a C-Corporation, medical costs, including health insurance premiums, are 100% tax-deductible to the corporation and tax-free to the recipient.
- C-Corporations can also pay for an employee’s education expenses (if they are directly related to the job), and these expenses are also deductible to the company and tax-free to the employee. The company can also contribute – and deduct – up to $5,250 per year for an employee’s non-job-related education expenses.
- A C-corporation can provide tax-free financial and tax planning to help employees, provided this benefit is part of a written employee benefit plan.
- C-Corporations can deduct insurance disability insurance premiums for employees, and can provide employees and/or former employees with $50,000 in tax-free life insurance. Premiums paid for these policies are tax-deductible to the corporation.
- A shareholder can borrow up to $10,000 from a C-Corporation, interest-free. Tax-free loans are not available to sole proprietors, partners, LLC members, or S-Corporation shareholders.
S-Corporations pass income through to their shareholders, who pay tax on it according to their individual income tax rates. To qualify for S-Corporation status, the corporation must have less than 100 shareholders; all shareholders must be individual U.S. citizens, resident aliens, other S-Corporations, or an electing small business trust; the corporation may have only one class of stock; and all shareholders must consent in writing to the S-Corporation status.
Electing S-Corporation tax treatment eliminates any possibility of the “double taxation” referenced above. S-Corporations pay no federal corporate income tax, but must file annual tax returns. Because losses also flow through, shareholders who are active in the business can take most business operating losses on their individual tax returns.
S-Corporations must still file and pay employment taxes on employees, as with a C-Corporation. An S-Corporation may not retain earnings for future growth without the shareholders paying tax on them. The taxable profits of an S-Corporation pass through to the shareholders in the year they are earned.
S-Corporations cannot provide the full range of fringe benefits that a C-Corporation can.
Own Your Own Corporation, by Garrett Sutton, Esq.
Tax Savvy for Small Business, by Frederick W. Daily
Publication 15B, Employer’s Tax Guide to Fringe Benefits, Internal Revenue Service