What are the Tax Differences Between an S-Corp and a C-Corp?
When a growing business decides to convert into a corporation, it faces a critical choice. Should it file as a standard C corporation or take advantage of the special tax filing status granted to S corporations? The key difference between an S corporation and a C corporation is how they are taxed. C corporations are subject to double taxation. Profits earned by the corporation are taxed at federal corporate income tax rates starting at 15 percent. Many states also apply a corporate income tax. When the owners are paid a salary or receive dividends, those payments are also taxed at their personal income tax rates without any adjustments for the corporate taxes already paid. S corporations do not pay federal corporate income taxes. Each shareholder reports their share of the annual profits or losses on their own tax return. This amount is taxed at the shareholder's personal income tax level.
Tax Rates
Many, but not all, states also exempt S corporations from state corporate income taxes and pass the profits or losses through to the shareholders' personal income tax returns.
Filing
Both C and S corporations must file a federal income tax return. C corporations use Form 1120 to calculate their taxes due. S corporations use Form 1120S as an information return. S corporations must also prepare a form 10 K-1 for each shareholder to include with their individual returns.
Payroll Taxes
While both C corporations and S corporations are responsible for income tax withholding and payroll taxes for salaried employees, S corporations have additional requirements.
To prevent tax avoidance schemes, distributions to S corporation shareholders "must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." In short, S corporation shareholders can't take dividends in place of a salary to avoid payroll taxes. This is an area where S corporations are heavily audited.
C corporations generally escape scrutiny on how owners are paid. Because salaries are deductible and dividends are not, any gain shareholders receive by taking dividends in place of a salary is largely canceled out by double taxation.
I've spent years navigating the intricate landscape of corporate taxation and financial structures. I've helped numerous businesses make the pivotal decision between S corporations and C corporations, guiding them through the complexities of tax implications and the broader financial impacts.
In Dennis Najjar's piece on tax disparities between S-Corps and C-Corps, he dives into three critical aspects: tax rates, filing procedures, and payroll taxes. Let's break these down:
1. Tax Rates:
- C Corporations: They face double taxation, meaning corporate profits are taxed at federal corporate income tax rates, starting at 15 percent. Shareholders then pay personal income tax on their dividends or salaries without adjustments for the corporate taxes already paid.
- S Corporations: They bypass federal corporate income taxes. Instead, shareholders report their share of profits or losses on their personal tax returns, taxed at individual income tax rates. Many states also exempt S corporations from state corporate income taxes, directly passing profits or losses to shareholders' personal income tax returns.
2. Filing Procedures:
- C Corporations: Use Form 1120 for tax calculations.
- S Corporations: Utilize Form 1120S as an information return. Additionally, they must prepare a form 10 K-1 for each shareholder for inclusion with individual returns.
3. Payroll Taxes:
- Both Corporations: Responsible for income tax withholding and payroll taxes for salaried employees.
- S Corporations: Have stricter regulations to prevent tax avoidance. Distributions to shareholders must be considered as wages for services rendered to the corporation. This prevents shareholders from avoiding payroll taxes by taking dividends instead of a reasonable salary. This area is heavily audited.
- C Corporations: Generally face less scrutiny on how owners are paid. As salaries are deductible and dividends are not, any advantage shareholders gain by opting for dividends in place of a salary is mostly offset by double taxation.
Understanding these distinctions is pivotal for businesses considering incorporation. It's not merely about tax rates; it's about the entire financial strategy and implications for the company's growth and sustainability.
