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C Corporations and S Corporations

C Corporations

This is the most common type of corporation. Because C corporations can have an unlimited number of shareholders, it is the structure of choice for companies planning to have a large shareholder base or publicly traded stock. 

Unless a corporation qualifies for and chooses to be an S corporation, it is automatically classified as a C corporation. A C corporation pays taxes on its profits, and files a Form 1120 with the IRS. Any excess profit is then distributed to the corporation's owners, or stockholders. These profit distributions are called dividends, and the stockholders must pay income taxes on them. This is why it is said that a C corporation results in "double taxation." Notice that the corporation's profits are taxed twice: Once at the corporate level, and again when distributed to the owners.

Due to this double taxation, most small businesses are not well served by being a C corporation. That said, there are very limited circumstances where a C corporation can be used by a small business owner in order to gain certain tax advantages. Check with your tax advisor.

S Corporations

S corporations are corporations who elect to be taxed as a "pass-through" entity (as if the owners were sole proprietors or partners). All corporate profits and stock dividends are reported by the owners as personal income. This type of structure blends the tax advantages of a sole proprietorship or partnership with the limited liability and prestige of a corporation. Many small businesses elect this status. To be eligible for this status:

• All shareholders must be citizens or permanent residents of the United States ,

• The number of shareholders may not exceed 100,

• Only one class of stock may be issued,

• No more than 25% of gross corporate income may be derived from passive income, and

• If held by a small business trust, the beneficiaries of the trust must be individuals, estates or charitable organizations. 

• Banking institutions, insurance companies taxed under Subchapter L and certain affiliated corporation groups are ineligibl e.

Subchapter S of the Internal Revenue Code was created and reworked by Congress late in in the 20th Century in order to allow small business owners to incorporate without being subject to double taxation. Thus, the "S corporation" was born, and has been the preferred tax structure for small businesses ever since (but see the section on LLCs below).

With an S corporation, the corporation files a Form 1120S with the IRS, but the corporation does not pay income tax (with a few rare exceptions). Rather, each owner pays tax on her share of the corporation's profits, much like a partner in a partnership. The difference here of course, is that since it is a corporation under state law, there are none of the legal liability problems associated with partnerships. And since the corporation does not pay income tax, there is no double taxation as there is with a C corporation. In effect, it allows a corporation to be taxed like a partnership.