Your private practice has a few options when it comes to the legal structure of your company. Two of the most common include a Limited Liability Corporation (with a business name ending in “LLC”) or a regular corporation (with a business name ending in “Inc”). So, where do S-Corp and C-Corp status come into the picture?
Legal Structure vs. Tax Structure
When you go to form the legal structure of your company, you’ll be filing your Articles of Organization with the Secretary of State. You can file in your state of residence or any other state in the country. Filing in a state in which you do not reside might have certain advantages. For instance, South Dakota is a popular place to form a business as there is no corporate income tax at the state level.
Regardless of which state you choose to form your business in, there’s an important distinction between the legal structure, which is decided at the time of filing, and the tax structure, which can be changed later. When setting up your business, there are different forms for an LLC and a corporation and you cannot hop between them. If you choose one and later want the other, you would have to dissolve the original entity and file new Articles of Organization to start a different entity.
However, whether you set up an LLC or a corporation in your state, you still have the option of choosing to be taxed as an S-Corp or a C-Corp because these statuses represent tax structures, not legal structures.
Most LLCs default to pass-through tax status, while corporations default to C-Corp tax status. If you meet certain requirements, you can elect for your LLC to be taxed as a C-Corp or S-Corp. Meanwhile, you could also elect for your C-Corp to be treated as an S-Corp. Let’s take a closer look at what those terms mean.
What is an S-Corp?
An S-Corporation is a type of pass-through entity, which means that all income and losses will pass through the corporation to the personal tax returns of the company’s owner(s). In the case of a single-owner S-Corp, this means 100% of the business’s finances will end up on your personal tax return alongside any other income you need to report. If there are multiple owners, you will divide the incomes and losses between yourself.
So far, it might sound like an S-Corporation is no different from being taxed as a sole proprietor, but that’s not quite the case. When you have a company that is taxed as an S-Corp, you must file an information return to the IRS known as Form 1120S. This form doesn’t require any fees or taxes to be paid, but it provides the IRS with information on annual income, deductions, profits, losses, and tax credits taken by the corporation.
Another form involved with an S-Corporation is Schedule K-1. This document is issued by the corporation owners to shareholders, and it must tell the shareholders how their shares connect to the item on Form 1120S. Shareholders will then file Schedule E with their personal tax return to account for any income or losses resulting from their corporate shares.
The primary advantages of opting for an S-Corp over a C-Corp include
- No corporate-level income tax. All income that is distributed to owners and shareholders will be taxed at the individual level.
- Pass-through entities like S-Corporations may be able to take the 20% qualified business income (QBI) deduction, reducing taxable income.
- Losses pass through to owners and shareholders, which can be used to offset other income (although some legal restrictions apply).
The primary disadvantages of opting for an S-Corp over a C-Corp include:
- You can have no more than 100 shareholders, which means an S-Corporation cannot be traded publicly. Additionally, limited shareholders can inhibit your ability to raise investor capital.
- With certain exceptions, all shareholders must be individuals residing in the United States, which can make it harder to obtain equity financing since most venture capital and private equity investors won’t qualify.
- Preferred stock is not permitted, which can deter investors since they often want certain privileges like preferences for distributions.
What is a C-Corp?
Unlike S-Corporations, which are pass-through entities, a C-Corporation is a completely separate taxable entity that creates financial separation between owners/shareholders and the business. This means that your practice would need to file taxes separately from any persons involved, which requires Form 1120, also known as a corporate tax return. As a result, the business will also need to pay taxes at the corporate level.
One of the most commonly discussed aspects of a C-Corporation is “double taxation.” This term is used to describe the fact that business income is taxed at the corporate level before being distributed to business owners as dividends, with that money then taxed again as personal income. However, unlike an S-Corp, C-Corporations do not have to distribute all earnings as dividends.
There are a number of ways to reduce the taxes you’ll pay as a C-Corporation and one of them is to pay shareholders wages for the services they render as an employee. The wages you pay in this capacity will be deductible for the corporation and only taxed at the individual level, which removes double taxation.
Another way to reduce corporate-level taxation is through fringe benefits, which can cover things like health insurance, company cars, and any education you provide. Of course, you’ll want to run all of these strategies by your tax advisor first, as the IRS keeps a watchful eye out for businesses misusing these classifications.
The primary advantages of opting for a C-Corp over an S-Corp include:
- Corporations are taxed at a lower maximum rate (21%) compared to personal tax rates, which can be as high as 37%. Especially if you are in a high personal income tax bracket, forming a C-Corp can be advantageous.
- C-Corps can have an unlimited number of shareholders and there are no restrictions on ownership or classes of stock. This makes it easier to raise investor capital.
The primary disadvantages of opting for a C-Corp over an S-Corp include:
- If income isn’t properly managed, you may end up with a heavy tax burden due to “double taxation” of dividends.
To sum it up, here’s a look at the key similarities:
- Regardless of whether you are taxed as an S-Corp or C-Corp, both LLCs and corporations are a legal structure that provide personal liability protection.
- To form a corporation, you must file Articles of Organization with the Secretary of State in whichever state you choose to form your company. States make no distinction between C-Corps and S-Corps.
- Both S-Corps and C-Corps have a similar structure. Shareholders own the corporation, and the corporation owns the business. The shareholders elect a board of directors to oversee corporate affairs. The board of directors elects officers to run the business.
To sum it up, here’s a look at the key differences:
- S-Corporations are pass-through entities whereas C-Corporations are separate taxable entities.
- S-Corporations are limited to 100 shareholders in total and all shareholders must be residents of the United States. C-Corporations do not have any shareholder restrictions.
- S-Corporations cannot be owned by a C-Corp, LLC, partnership, or most trusts. They usually cannot be owned by another S-Corp, either. Meanwhile, C-Corps can be owned by any entity.
If you’re starting a private practice or looking for ways to grow your existing practice, opting for a new legal and tax structure may be a smart move. Now that you know the difference between an S-Corp and a C-Corp, take the time to consult with your tax advisor to see what’s the best fit for your goals.