Business Entity Decisions – Should My Business be a C-Corp or S-Corp?

One of the first decisions in starting a business is the selection of the form of the entity. Factors to consider include taxability issues, ownership flexibility, selection of year-end, fringe benefits, limitation of liability, accounting methods, basis issues, allocations of income or loss and compensation. In addition, certain forms of entity are more conducive to specific industry types. The more common entity types include Corporations (both “C” corporation and “S” corporation); Partnerships (either general or limited); Limited Liability Company (LLC) and Sole Proprietorship. All have their own advantages and disadvantages.

This article examines “C” Corporations and “S” Corporations.

C-Corporation

A “C” corporation is a legal entity, separate from its owners and is taxed on its own profits. The flat corporate rate of 21% is currently less than the maximum individual rate of its shareholder(s) which provides avenues for tax planning. Liability is limited and ownership is flexible in that there is no limitation on the number and type of shareholder, classes of stock and ownership is easily transferred. There are no limitations on the selection of year end allowing for different reporting periods for the corporation and its shareholders, providing tax planning opportunities. Other advantages include treatment of fringe benefits, capital gain treatment on sale of stock ownership, a preferential tax rate on qualified dividend distributions to owners, and centralized management. Disadvantages include double taxation on liquidation or a non-stock sale of the business, limitations on the use of cash basis method of accounting and potential unreasonably high compensation issues. Professional service corporations (PSC) are often organized as “C” corporations to realize the fringe benefit advantage. Although PSC’s are limited to an extent on selection of their tax year, unreasonable compensation is typically not an issue. A “C” corporation is generally inappropriate for an entity owning assets that will appreciate, particularly real estate.

S-Corporation

An “S” corporation is a legal entity, separate from its owners, but profit or losses generally flow through to the owner shareholders (accordingly, the “flow-through” designation). In order to be treated as an “S” corporation, an election must be filed with the Internal Revenue Service. Certain states require their own election be filed. Liability is limited but ownership is somewhat inflexible due to restrictions on the types of shareholders, number of shareholders and a one class of stock limitation. Selection of year end is limited; typically the corporation will report on a calendar year. The recently enacted Tax Cuts and Jobs Act provides a 20% deduction for qualified business income which is beyond the scope of this article. Other advantages include avoidance of double taxation on income or upon liquidation or sale of assets, ability to deduct operating losses (within the confines of basis availability) and the ability to minimize payroll taxes and self-employment tax. Disadvantages include treatment of fringe benefits, shareholder basis issues, unreasonably low compensation issues, limitations on methods of accounting and inability to specially allocate income, losses and distributions. In general, an entity which anticipates incurring losses in the formative years should elect treatment as an “S” corporation to facilitate the deduction of the loss at the shareholder level. In these situations, particular attention should be given to basis issues.

Both “C” corporations and “S” corporations can be useful selections as an entity. Careful deliberation should be given to the advantages and disadvantages of both entity types and the prospective owner(s) should consider short term conditions such as initial operating losses, priorities such as fringe benefits or compensation issues and long term plans such as an eventual sale of the business. Your accountant advisor is an integral part of this process.
The right business entity affects many parts of your business. Contact Alloy Silverstein for assistance in your entity decision making.