What's the difference between an "S" corporation and a "C" corporation?

What is meant by "S corporation"? Is an "S" corporation right for your business? What are the requirements for an S corporation?

There is a common wisdom among small business owners and founders of new startups that an "S" corporation is preferable to a "C" corporation. Are they right? Well, the correct answer is the attorney's standard response to most legal questions: "It depends."

For starters, you need to understand exactly what is meant by "S" corporation. An S corporation is not a particular type of corporation, rather, it is an "election" that you file with the Internal Revenue Service ("IRS") when you want your corporation to have a special tax treatment that is different from the standard corporation.

Here's what you need to know.

Many people use the term S corporation interchangeably with "small business corporation." That is not necessarily correct. Under Nevada corporation law, there is no such thing as an S corporation. Nevada statutes recognize certain specific types of corporations: Private Corporations, Close corporations, Benefit Corporations, Non-profit Corporations, Professional Corporations, and Corporations Sole. Each has unique characteristics under Nevada law, and you should always seek legal advice to decide which type works for your particular enterprise.

Far and away, the most common corporation type filed in Nevada is the Private Corporation. This is the form most often suited to enterprises engaged in business for profit. Every state in the Union has a statute enabling Private Corporations. The laws governing private corporations vary somewhat from state to state, but most states have adopted the Uniform Corporation Law, which is based on the "common law" of corporations we inherited from the English law hundreds of years ago. In Nevada, the private corporation law is encoded in Chapter 78 of the Nevada Revised Statutes. The statute includes such laws as the state registration requirement, qualifications for directors, fiduciary duties of directors and executive officers, shareholder rights, and various other rights and duties attendant to the corporate structure.

The "S" and "C" modifiers have nothing to do with Nevada corporation law, but are functions of tax law under the Internal Revenue Code ("IRC"). By default, a state-chartered corporation is taxed under Subchapter "C" of the IRC. That means that the corporation itself files an annual tax return, and pays tax on its net profits. If the net profits are sufficient, the Board of Directors may elect to pay a "dividend" payment to the shareholders, which is distributed in pro-rata share depending upon the proportionate stock ownership of each shareholder. The shareholder receiving the dividend payment must report it as income on his or her individual tax return. This is the infamous "double taxation" that is characteristic of the corporation form (i.e., the corporation pays tax on the profits, then the shareholders pay tax again when they receive the dividend payment).

Clearly, double taxation of income is not a good thing, and should be avoided if possible. That is why many startups and small businesses think that they should file an "S" election.

A "C" corporation (the default) becomes a Subchapter S ("Sub-S") corporation when it files a form with the Internal Revenue Service ("IRS") electing to be taxed as a "pass-through" entity. To be clear, when you file the election it is the same corporation, operating under the same Nevada law (Chapter 78), but will be taxed differently. If you elect "Sub-S" status, then your corporation will file an information-only return, but will not pay tax. Rather, any profits distributed to the shareholders will be included in each shareholder's individual tax return, and taxed at the shareholder's individual tax rate. Likewise, if the corporation incurs losses for a year, the losses can be a deduction on the individual shareholder's return.

So now we return to the "presumption" that double-taxation should be avoided. Sometimes that is true, but oftentimes it is not. It depends on the company, where it is, and where it is going. First, let's identify the IRS's conditions to qualify as an "S" corporation. In order to make the "Sub-S" election, a corporation must satisfy certain specific requirements:

• The corporation must be a domestic corporation (i.e., not a foreign corporation doing business in the U.S.)

• The corporation must have ONLY "allowable" shareholders.

  • Includes individuals, certain trusts, and estates

  • May NOT be partnerships, corporations, or non-resident aliens

• The corporation must have no more than 100 total shareholders

• The corporation must have only ONE class of stock

• The corporation must not be an "ineligible" corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)

If your corporation meets all the requirements, you can file the Sub-S election. But that doesn't necessarily mean you SHOULD file the election.

There are a number of factors to consider before electing Sub-S tax treatment. If you expect your business to always remain a "small business," for example, a local dry cleaner or a car wash, Sub-S may work for you. You can bring in a limited number of investors, all of whom will be issued "common stock." Common stock is the default, the class of stock you must declare when you register your corporation with the Nevada Secretary of State. "Common stock" means that every common shareholder owns an interest in the corporation that is proportionate to the number of shares owned, versus the total number of shares issued and outstanding. So for example, if your corporation has issued a total of 100,000 shares (including founders' shares), then the owner of 10,000 shares owns one-tenth of the company. If you don't expect to EVER bring in more than the 100 allowed shareholders, or any shareholders that would disqualify you from "S" status, then you should consider filing the "S" status election.

On the other hand, most startup businesses will depend on investor capital to take them through their first several years of growth. Typically, early-stage operations are funded by investor capital, and there are no profits realized or even expected during the first few years while the company builds its brand and infiltrates its market. If there are no profits to distribute, then there is no possibility of "double-taxation". Founders and early-stage investors are "betting on the come." That is to say, they are hoping that the company will eventually develop a market for its good or services that may become profitable in the future. If and when that happens, they hope that the company will increase in value and the investors will be able to sell their stock at a substantial profit.

But in today's capital market, early-stage investors don't want to be just another common stock holder. To induce them to invest, you will have to offer them "preferred stock" (rather than common), the terms of which are negotiable. Preferred stock investors will ask for additional rights, such as the right to convert their stock to common at a favorable conversion ratio, the right to stock options or warrants, the right to a bonus if the company is acquired by a larger company, the right to appoint members to the board of directors, or other rights intended to protect their investment and maximize their return. Most successful startups go through at least one round of financing involving preferred stock, so an "S" corporation would not be able to attract or benefit from these investors, since "S" status allows only common stock.

Another consideration is the current tax rates. Under current law, "C" corporations are taxed at a flat rate of 21%. If S-corp profits are passed through, the individual shareholders will pay tax at the individual rate, which could be as high as 37%. Since small and startup businesses typically reinvest all of their profits in the business anyway, it is preferable to pay the corporate rate rather than pass through the profits to the shareholders

"C" corporations have another valuable option as well, which is that they can issue incentive stock options to employees and vendors. If you are recruiting key personnel to help the business succeed and grow, or need to woo venders and maybe get discounts from them, you will want to be able to offer stock options in order to recruit the best people and incentive your suppliers.

If you are unsure of whether to make the "S" election, give us a call and we can help you work it out.