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.
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.
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.
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.