If you are researching how to set up your business structure, you’ve come to the right blog. Educating yourself properly will help you avoid many costly mistakes. Below, we will discuss the main differences between S Corporations and C Corporations in the tax context (since we are tax accountants). However, please consult a business attorney to review the legal aspects, especially if you have multiple shareholders.

Taxation Differences

S Corporations: S Corps are designed to avoid double taxation. Instead of paying federal income taxes at the corporate level, they pass their income, deductions, and credits through to their shareholders, who report them on their individual tax returns. However, keep in mind that in California, S Corps are still subject to double taxation. S Corps pay either $800 a year or 1.5% of net income, whichever is higher.

C Corporations: C Corps are taxed separately from their owners. They pay corporate income tax on their profits at a federal rate of 21% and they pay to California $800 or 8.84% of net income (whatever is higher). Shareholders also pay personal income taxes on dividends they receive from the corporation. This results in what is known as "double taxation": once at the corporate level and again at the shareholder level.

C Corps are often preferred by larger businesses, those with more than 100 shareholders, international investors, or startups planning to go public. They can also be advantageous for holding companies or for taxpayers with significant medical expenses and fringe benefits they wish to deduct. We wrote more about deductability of medical expenses here.

What is an S Corporation?

An S Corporation is a specific tax classification under the IRS code for what is known as a pass-through entity. As we mentioned before, this classification allows a business owner to pass business income and losses directly to their individual level and avoid corporate-level taxation. This can be beneficial since the individual’s average tax rate is typically less than the corporate rates.

Another common reason for setting up an S Corp is to legally avoid paying additional Social Security and Medicare taxes (also known as self-employment taxes). Recall that Social Security taxes stop at $160,200 of your wages (for the 2023 year), but Medicare taxes continue into perpetuity. Taxpayers save on Social Security and Medicare taxes by claiming lower wages (which are subject to those taxes) and they don't pay self employment taxes on the rest of their income. For very profitable companies, the S Corp setup can still be beneficial even if they pay a full salary up to the Social Security threshold of $160,200. This is because Medicare wages do not have an income threshold on the W-2. For example, if the company’s net profit is $2,000,000 and the salary is $400,000 (meaning they have paid all possible Social Security tax), the owner is still saving around $60,000 on Medicare taxes (which are at 3.8% of wages). ($1,600,000*.038=$60,800)

However, the IRS scrutinizes S Corp compensation levels to ensure they are “reasonable.” They want you to explain how you arrived at the number on your W-2, and an answer like “I wanted to pay less in self-employment tax” would be incorrect. You can read on reasonable compensation rules here.

Contrary to belief, S Corporations are never formed by themselves. They are spawned from an entity on the state level, such as an LLC or a corporation that elects to be taxed as an S Corp on the federal level. After the S Corp election is made, your entity becomes an S Corp, but the underlying entity on the state level does not change. Many business owners say, "I have an LLC taxed as an S Corp." But they could rightfully just say, "I have an S Corp." For tax purposes, those are the same things. Tomato, tomato.

Interestingly, a C Corporation converted to an S Corporation in California can benefit from savings on SDI (disability insurance) taxes, potentially saving $1,387 annually in 2023. This works only when the S Corp has only one shareholder. However, if an S Corp is set up as an LLC, it does not have this option, and the owner has to pay SDI taxes from their wages. Here is more about it.

What is a C Corporation?

A C Corp pays taxes twice on income: the business pays corporate taxes, and then individual shareholders pay income taxes on any salary they receive, plus dividends from business profits.

C Corps have an option to reduce their tax liability by drawing a large salary for the officer and deducting it on the C Corp tax return. This would avoid corporate taxes since the taxable income would be brought down to zero by a large salary expense. However, this tactic shifts all tax liability to the officer, who would have to pay regular tax (in their own tax bracket) along with Social Security and Medicare taxes on these wages. The IRS can also question the reasonableness of the compensation, but now in the context of a C Corp. Large wages used to reduce the taxable income of a C Corporation are also scrutinized by the IRS.

Both S Corps and C Corps come with benefits and disadvantages. Here are the main differences:

S Corporation Benefits:

• No federal corporate taxes (California still double taxes).
• Potential savings on self-employment taxes compared to sole proprietorships.
• Eligibility for a 20% pass-through deduction on qualified business income. We wrote more about it here.
• Ability to claim business losses on personal returns to reduce personal taxable income.

S Corporation Disadvantages:

• Limited to 100 shareholders.
• No non-resident shareholders allowed.
• Not all entities can be S Corp shareholders. You can read about it here

C Corporation Benefits:

• No limit on the number of shareholders.
• Shareholders can be non-U.S. residents.
• Suitable for businesses seeking to attract investors or prepare for a public offering.
• Allows for deductions on health benefits and other fringe benefits.

C Corporation Disadvantages:

• Double taxation of business income.
• No QBI deduction.

Is it better to be an S Corp or C Corp?

If you are just starting your business in California and do not know your projected net income, we always suggest starting as a sole proprietor who files Schedule C (which is completely different from a C corp). We also suggest not getting into an LLC unless you really need to for legal reasons. California LLC is $800 a year, plus it would cost you $200–$300 in filing fees. So, just getting an LLC in California will cost you around $1,000. Why not get good insurance coverage for the same amount of money and avoid the headache?

As your business grows and you reach the appropriate income threshold, you can either set up an LLC and convert it to an S Corp or set up a C Corporation and convert it to an S Corp. With an LLC setup, you are allowed to request S Corp status retroactively. For example, you might start the year as an LLC without knowing if an S Corp makes financial sense (S Corp accounting fees can be hefty), but then realize that you made too much money that year and S Corp status is what you want. In this case, you are allowed to request S Corp status as of the beginning of the year, even though it is now the end of the year. However, if you initially set up as a C Corp, you don’t get that late-filing election benefit, but you can benefit from not paying SDI taxes on wages, as mentioned above.

In California, many professionals don’t have the option to create an LLC. For those individuals, there are only two options: stay a Schedule C filer with good liability insurance or go for a C Corp that is converted to an S Corp from the very start.

Apart from the income considerations, you may be a fit for an S Corp if you answer “yes” to these questions:

• Am I a U.S. resident with 100 or fewer shareholders in the business?
• Do I want to save money on self-employment taxes?
• Do I mind passing through corporate taxes on my individual level and paying taxes in my individual tax bracket?

You may be a fit for a C Corp if you answer “yes” to these questions:

• Would I like to go public in the future?
• Am I a U.S. non-resident?
• Do I have a lot of fringe benefits/medical expenses that I would like to deduct?

Each structure has its own set of advantages and challenges, so it’s important to evaluate your specific needs and consult with tax and legal professionals to determine the best option for your business.