Deciding on an appropriate type of structure or entity for your business is an important part successfully running an operation on a long-term basis. Taxes are a big consideration for many when trying to figure out what type of entity offers the most efficient and advantageous vehicle for their business purposes. There are certainly other considerations such as liability, legal and practical use especially if partners are involved. However, taxes remain a key component and deciding factor for many business owners.
The primary difference in a “C” corporation versus an “S” corporation is in most cases “C” corporations pay taxes at a corporate rate as opposed to personal income tax brackets. This is because “S” corporations are “flow-through entities” which means the profits and/or losses flow through directly to the owners and shareholders of the corporation and get reported on their personal income tax returns.
With a “C” corporation the owners generally take a salary which is reported and taxed on their personal returns while the corporation files a return as well and is taxed on the profits. Additionally, if any end of the year or additional lump sum distributions are made, they can be taxed yet again as dividends to the shareholders.
“S” Corporations are subject to the same taxation issues when it comes to dividend distributions but are considered by many as a simpler form of incorporation because the profits flow directly through to shareholder tax returns and you do not have to deal with filing multiple returns with multiple tax brackets, corporate versus personal.
The profit that is reported on each shareholder’s personal tax return is directly related to their overall percentage of ownership in an “S” corporation. Therefore, if owner A has a 40% share of a business that is incorporated as an “S” corporation and owner B has a 60% share, and the total profit of the company is $100,000, then owner A would be responsible for reporting $40,000 on his return and owner B $60,000 on theirs.
Because the taxation and workings are fairly straightforward “S” corporations are the choice of many business owners and partners. However, the one advantage that “C” corporations can have is the offer of corporate tax rates versus personal tax brackets if the current environment has relatively high personal income tax rates. Corporate tax rates historically are a little less volatile versus personal tax rates and, therefore, may offer some flexibility to business owners in some cases.
Many years ago, “C” corporations were largely preferred and in recent years the tables have turned with “S” corporations now leading the pack as the most preferred entity from a simplicity and tax point of view. Yet a third choice is forming an LLC or Limited Liability Company which offers a different set of rules but is similar to an “S” corporation in some ways.
Regardless of what type of entity you choose it is important to understand the current requirements and regulations involved with the tax treatment of your business. Small mistakes and not fully understanding the IRS guidelines can end up being very costly and ultimately result in large fines and penalties if you are not careful.