When we talk about corporations, we either talk about an S Corporation or a C Corporation. There is a huge difference between these two, and understanding this difference is important to your personal wealth.
I see this a lot with professionals in California. I California, the majority of licensed professionals are not allowed to set up LLCs; instead, they can either be sole proprietors or corporations. Sometimes these licensed professionals jump into C Corps, thinking that this is their final destination since this is what the state allows and recommends.
For for many small business owners, a C Corporation status is disadvantageous. But by the time this fact gets discovered (usually during tax time, and only if they’re lucky), a lot of tax planning opportunities have been missed.
So, what’s the main difference between a C Corp and an S Corp, and what’s all this rave about S Corps on the internet?
Well, the key challenge associated with C corporations is the issue of double taxation. This is because a C Corp's earnings are taxed at the corporate level and again when shareholders receive dividends. We are probably all okay with the big businesses we invest in being taxed as corporations (such as Microsoft, Tesla, Apple, and so on). But this is because we’re investors and not business owners and we pay tax only once on the dividends we receive. But no business owner likes to be taxed twice on their own business, and the S Corp status solves this problem beautifully: It allows income, deductions, credits, gains, and losses to pass directly to shareholders, who then handle their tax issues at the personal level. At the same time, S Corporations offer the same protection from creditors as C Corporations.
How do C Corp owners get their money out of C Corps? Most small business owners who got stuck in a C Corp for one reason or another usually issue themselves a big paycheck and zero out the company's profits so that the C corp has zero taxable income left and is not required to pay corporate taxes. However, business owners must pay self-employment taxes on their C Corp salaries ( which is roughly additional 15 %). If they do leave money in the C Corp, the business entity would have to pay corporate taxes on it and the remaining balance could be taken out as a dividend, which of course, will be taxed again on the personal level of the business owner.
S Corps are so much tax efficient in this regard. S Corp owners can take their money both as salary and distributions and distributions are not being taxed on the corporate level.
But here are additional advantages of S Corp status people on the internet rarely talk about:
- Generating Capital Gains for the Owners: An S Corporation can create capital gains for its owner by using borrowed funds. These capital gains can offset capital losses of its owners that would otherwise be carried forward. For example, if an S Corp takes out a loan and then distributes these funds to the owner, and the distribution exceeds the shareholder's basis, it is considered a capital gain for the shareholder. Capital gains, as we know, offset capital losses—a good tax planning strategy when done on purpose. We talked more about this strategy here.
- No Payroll Taxes on Distributions: The famous "self-employment tax avoidance" tool. Distributions from an S Corporation to shareholders are not subject to payroll taxes, meaning Social Security, unemployment, and Medicare taxes aren’t applicable. Please note: the business owner still pays ordinary tax on S Corp income. This is where the concept of reasonable compensation comes in, which basically means you can’t completely avoid self-employment tax. If you want to get money out of your S Corp, please be kind and pay up some self-employment tax on your distributions. We discuss the concept of distributions here.
- No Accumulated Earnings Tax: Unlike C Corporations, S Corporations aren’t subject to the accumulated earnings tax, which penalizes C Corporations that accumulate excessive earnings without distributing some to shareholders. This means that the business owner can keep the cash in the S Corp’s account as long as they please without any consequences.
- Offsetting Passive Losses: If a shareholder doesn’t actively manage the business, any income passed through from the S Corporation is considered passive. If the shareholder has other passive losses from other activities, these losses will mitigate passive gains from the S Corp. You can read more on this topic here. This tax planning strategy doesn’t work with C Corps.
- Tax Savings with Health Insurance: This is a minor one. In reality, you save only on self-employment tax on the amount of health insurance premiums. We discussed it in detail here.
Of course, these are only advantages. In most cases, an S Corp is just what the small business owner needs. However, C Corps also have many applicable uses and can be very handy if used properly. Before jumping all into an S Corp and filing that Form 2553 election that everyone is talking about (by the way, you can find it here), please make sure to read our blog on disadvantages of S Corps as well.
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