What is a Corporation?
A corporation is a legal entity and is considered a new “person” that has the capacity to, inter alia, enter into contracts, open and maintain bank accounts and file taxes. In addition, a corporation is legally separate from its shareholders who have limited liability for the corporation’s business debts, subject to certain exclusions. Corporations are subject to regulations at both the State and Federal level. In Florida, you can form a corporation online through Sunbiz here. The two types of corporations are a C-corporation (“C-corp”) and S-corporation (“S-corp”).
What are the benefits of forming a C-corp?
A C-corp entity formation is usually reserved for larger companies that wish to take advantage of a C-corp’s ability to exist perpetually and take on outside investment. Further, any company that wishes to become publicly traded must initially file as a C-corp or convert to become a C-corp. A C-corp has fewer ownership restrictions than an S-corp and is able to have an unlimited number of shareholders. Also, such shareholders are not required to be US citizens. This is apparent when looking at well-known companies such as Apple, Facebook and Google, to name a few.
C-corps have various tax benefits compared to other entities. The fiscal year of a single-member LLC that does not elect to be treated as a corporation, for instance, must conform to the tax year of its member (26 U.S. Code §1378(b)). By contrast, C-corps have more flexibility in determining their fiscal year, which can end on December 31st of the particular year or any other accounting period for which the corporation establishes a business purpose (Internal Revenue Service, Tax Years). Managers of seasonal business often leverage this flexibility and reduce the company’s tax burden by spreading income and expenses over the same sales cycles. More information can be found about filing as a C-corp here.
Additional benefits of C-corps come in the form of tax deductions, which can include charitable contributions and donations and access to Health Reimbursement Arrangements (“HRAs”). HRAs are employer-funded plans that allow a business to reimburse employees tax-free for medical expenses, co-payments and insurance premiums.
In addition to tax benefits, a C-corp can also offer prospective employees stock options. Stock options can help attract high-quality employees by aligning personal interests with the long-term goals of the company.
Is a C-corp the right entity for you?
While the above highlights benefits to forming a C-Corp, the entity type does not come without some additional considerations, which is why companies not focused on offering public stock may want to explore other entity types. As an example, C-corps are subject to double taxation - tax applies at both the corporate level before dividends are disbursed to the shareholders and the shareholders are also taxed on the dividends at a personal level. The corporate tax rate typically ranges from 15 percent to 35 percent. Moreover, C-corp shareholders cannot deduct business losses on their personal tax returns. As a result, most businesses, including small businesses may find an LLC or S-corp better align with their financial objectives.
What are the benefits of forming an S-Corp?
An S-corp provides small business owners substantial benefits in comparison to an C-corp. S-corps are considered pass-through entities, which means a shareholder’s dividends are only taxed at the personal income level. Companies are often structured as S-corps when the shareholders anticipate operating at a loss as those losses can be “passed through” to the company’s shareholders thereby reducing such shareholder’s personal tax liability.
One of the most coveted benefits of S-corp taxation is that the shareholders do not have to pay self-employment tax on the entirety of business profits. Indeed, the payments to S-corp shareholders occur through salaries and dividends. As an S-corp shareholder, you are not required to pay Social Security and Medicare taxes on distributions; however, you are required to pay a self-employment tax of 15.3 percent on salary (in addition to paying for payroll and a separate tax return). While it may seem tempting to shift all income to the “dividend” portion of earnings, the IRS must find that a shareholder’s salary is reasonable. Effectively, the IRS wants S-corps to pay owners the “market salary” that would be paid to someone else performing the same work. This is based on a variety of factors, including the specific industry, market data and individual experience. These factors are part of the analysis the IRS considers when evaluating whether or not a salary is “reasonable”. Discussing whether a salary is reasonable with your certified public accountant can help avoid IRS scrutiny and potentially losing S-corp status.
In addition to tax benefits, S-corps also have more ownership flexibility than C-corps. Subject to certain exclusions, trusts and estates are permitted to be shareholders of S-corps, adding some versatility to an entrepreneur’s resource list. To form an S-Corp in the State of Florida, one needs to file an Articles of Incorporation with the secretary of state in addition to an IRS Form 2533. More information can be found about filing as a S-corp here.
What are the drawbacks of forming an S-Corp?
Structuring as an S-corp may not make sense for everyone. Certain companies in the banking and insurance industry are prohibited from becoming S-crops. Additionally, S-corps typically have more record keeping and reporting requirements than an LLC. As an example, and unlike an LLC, S-corps are required to hold annual meetings and keep minutes of those meetings. Furthermore, S-corps are only allowed to issue only one class of stock, which limits ownership versatility. By contrast, C-corps can issue multiple classes of stock, which is helpful to differentiate the tiers of shareholders’ voting rights. Also, S-corps have restrictions on ownership. In Florida, an S-corp can only have 75 shareholders and shareholders of an S-corp must be US citizens or resident aliens.
Whichever business entity you are considering, it is advisable to speak with a business law attorney about which option is the best fit for your goals and objectives. If you have questions about business entity formation, contact our office today to learn more.