Entity selection is a big decision new small business owners must make, and the decision to incorporate comes with tax ramifications.
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Deciding the difference between a C Corp and an S Corp should include a tax professional and an attorney. The attorney can address the liability and legal issues of incorporating and the tax professional can explain the tax consequences and even worksheet anticipated liabilities based on the actual situation.
While there is software and online tools that can incorporate a company for less than $200, spending some money upfront on legal advice could pay off in the long run.
Besides incorporating, you may have to consider things like contracts between yourself, your partners if applicable, and the corporation. There’s also employee non-compete agreements and possibly copyright and trademark protection documents that should be taken into account. An attorney will likely bring up other aspects that pertain to your business that you hadn’t previously considered.
All corporations are founded as C corporations. To become an S corporation, you must file IRS Form 2553 to make the election to be treated as such.
A corporation is a self-contained separate entity, which formalizes the business and separates the activities of the business from your personal activities. One of the main reasons a business incorporates is to protect the personal assets of the shareholders from lawsuits and creditors.
Here are the tax ramifications about the treatment of transactions depending upon whether you are a C Corporation or an S Corporation.
Similarities of C and S Corporate Structure:
- Books, records, and bank accounts are kept separate from personal books and records. The corporation is a formal entity and personal transactions should not be comingled with business transactions.
- Depending upon the state in which you live, you may be required to file an annual statement of officers with your state taxing agency and pay a nominal fee.
- Depending upon the state in which you live, you may be required to pay a minimum franchise tax.
- The principals of the corporation should hold board of directors meetings at least on an annual basis.
- All working owners are required to be on payroll. Payroll taxes must be withheld and matched and the rate of pay must be reasonable. If audited and this rule is violated, the IRS may reclassify “draws” as wages and collect payroll taxes as well as penalties and interest.
Differences between a C and S corporate structure:
- A C Corporation files a standalone tax return and pays taxes at the corporate level. Losses may be carried forward or backward. The maximum tax rate for a corporation is currently 35%. An S Corporation files a tax return but the profit or loss passes through via Form 1120S K-1 to the individual income tax return. The tax liability and the taxes are assessed and paid at the individual level. The maximum tax rate is 39.6%. Losses sustained in an S Corporation are applied to other income to reduce the tax liability of the shareholder.
- Owners in a C Corporation cannot arbitrarily draw funds the way a sole proprietor or partner in a partnership is able to do. Any funds drawn, unless a loan repayment or expense reimbursement will be classified as a dividend and subject to double taxation. That is, the corporation cannot take the deduction and owner is required to report the distribution on his income tax return. An S Corporation owner may draw funds against profit as long as he/she is paid reasonable compensation in the form of wages.
- The C Corporation enjoys a wide range of fringe benefits for employee owners not available to S Corporation owners, such as life insurance and disability insurance. More information on fringe benefits can be found in IRS Publication 15-B
- A C Corporation must pay estimated tax payments based on the C Corporation profit. The S Corporation might be subject to a state tax liability and therefore estimated tax payment depending upon the rules of the state in which it is formed. At the federal level, the S Corporation pays no income tax and is not subject to estimated tax payments. Each shareholder who receives a K-1 must factor in the profit or loss in determining the amount of estimated tax payments to be paid at the individual level.
For more information on this topic and to determine what is best for your situation, contact your attorney and tax professional. Also read IRS Publication 542 Corporations.