Choosing the correct form for your business entity is often a daunting task. There are several to choose from, and many entrepreneurs should seek guidance in selecting the proper form. This article touches on some of the most basic considerations in choosing between an S Corporation and C Corporation.
However, this is not to say that there are not more choices available, and when the business does not specifically choose a form, it defaults to a sole proprietor or partnership. For the sake of space, this article will stick to the corporate options. Of course, business owners are advised to consult with accountants, financial advisers and attorneys for a more in-depth analysis on entity selection.
The most basic corporate consideration is through taxes and earnings. A C Corp is subject to double taxation, whereas S Corp earnings are passed through pro rata to the shareholders and taxed at their marginal rates. In other words, income earned by the C Corp is first taxed at the applicable corporate tax rate. Then, the amounts distributed to the corporation’s shareholders are taxed again pursuant to the shareholder’s marginal rates. Conversely, an S Corp’s earnings are automatically passed through to the shareholders and taxed according to their marginal taxed rate — there is no taxation at the corporate level.
Self-employment taxes are another factor for corporations where the shareholders are also the employees. In an S Corp, the shareholders/employees needs to pay themselves reasonable wages, which are subject to self-employment tax (15.3 percent on the first $118,500 of wages). The remainder of the compensation can be paid out in distributions, which are not subject to self-employment tax. C Corps will have similar treatment, but keep in mind, C Corp distributions are also subject to the double taxation described above.
If fringe benefits are important, the C Corp structure begins to look more desirable. Group-term life insurance plans, medical/dental reimbursement plans, cafeteria plans and dependent care assistance plans can be deducted from corporate earnings and are not reported as income to the shareholders/employees. If the corporation’s shareholders constitute all employees, the corporation may minimize its taxable earnings by paying reasonable salary (which is subject to self-employment tax) and spending a majority of the remainder of earnings on fringe benefits. Also note that the corporate tax rate is 15 percent for the first $50,000 and 25 percent for the next $25,000 (18.33 percent on the cumulative total for the first $75,000). Generally, this is less than the personal marginal rate for most successful business owners. However, this is mitigated if all the income of the C Corp is paid out in salaries to the employed shareholders to minimize the double taxation problem.
C Corps also provide more flexibility in allocating different income rights, loss rights, cash flow rights and liquidation rights. Specifically, they allow different classes of stock to be issued to the shareholders that may come with different distribution, loss or liquidation preferences. S Corps are limited in their ability to provide different equity interests. All distributions, losses and liquidation events must be distributed pro-rata. Voting and non-voting stock may be issued in an S Corp, but otherwise, all stock has the same income, loss, cash flow and liquidation interests. Also keep in mind that corporations, partnerships and non-resident aliens cannot be shareholders of an S Corp.
Successful C Corporations might have Alternative Minimum Tax issues, especially upon receipt of life insurance proceeds for redeeming deceased owners’ stock. The AMT only affects C Corps with average annual gross receipts in excess of $7.5 million during a three-year period or $5 million during the entity’s first three years. Additionally, it only surfaces in the event it exceeds the corporation’s regular tax. If the C Corp owns life insurance policies on the shareholders and receives the death benefit, even though such proceeds are typically income tax free, the C Corp may trigger AMT. The solution is to elect a pass-through entity (such as an S Corp) or require the shareholders to individually own life insurance policies on each other, aiming for a cross purchase approach to deceased shareholders, rather than redemptions.
There are many other considerations at play when choosing entity form, and further choices aside from corporations. Consultation with accountants, financial advisors and attorneys can provide invaluable insight to this analysis.
Ian Burrell is an attorney with Stinar Zendejas and Gaithe. He can be reached at email@example.com.