C-Corp vs S-Corp: Which Is Best? - MarketWatch (2024)

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Though created under state law, the business entities discussed below are generally structured the same way across the board. Most states require businesses to file annual reports and pay business taxes to the state. Some states may offer generous tax cuts for certain types or categories of businesses, while some may have more burdensome taxation and filing requirements. Some offer many options for setting up an entity tailored closely to your business plans, and some offer a single one-size-fits-all option.

We won’t cover all the state nuances, but below we’ll explain key terms so you’ll have a general understanding of the types of business structures available.

Business Entity

A business entity is a legal entity formed under the laws of a state by one or more persons for the purpose of making a profit or engaging in commercial activity. Business structures can be formal or informal.

Informal business structures (sole proprietorships and partnerships) are created when one person or a group of people begin engaging in business activity — no paperwork or registration is necessary. Formal business entities (LLCs and corporations) are created by filing paperwork with a state agency, usually the office of the secretary of state.

Tax Status

Different types of business entities enjoy different “tax statuses,” meaning the taxes they owe to the state and federal governments are calculated differently. Generally, a business can either be considered a “pass-through” entity or a corporation.

A pass-through entity allows the profits of the business to “pass through” to the owners (sometimes called “members”) to be taxed as personal income. Corporations, on the other hand, are subject to “double taxation.” That means in addition to the personal income tax owners pay on what they earn from the business, the corporation pays a corporate tax on its profits.

Sole proprietorships and partnerships are always pass-through entities, and corporations are generally always subject to double taxation. An LLC is a pass-through entity by default, but can elect to be taxed as a corporation. LLCs and corporations can elect to be taxed as S-corporations, which treat some income as pass-through income.

Sole Proprietorship

A sole proprietorship is an informal business entity created when one person engages in commercial activity. No paperwork with the state is required. Income from a sole proprietorship passes through to the owner’s personal income for tax purposes. Sole proprietorships are referred to as “disregarded entities” by the Internal Revenue Service (IRS), because they are “disregarded” as separate from the sole proprietor, or owner.

Partnership

A partnership is created and functions the same way a sole proprietorship does, except a partnership involves two or more individuals as owners. No paperwork is required unless the owners want limited liability protection, in which case they can form one of the following:

• Limited partnership (LP)
• Limited liability partnership (LLP)
• Limited liability limited partnership (LLLP)

Not every state recognizes these types of partnerships.

Limited Liability Company

LLCs are hybrid business structures that are treated as pass-through entities for tax purposes but enjoy the limited liability protections of corporations. With limited liability, owners of the LLC (called members) protect their personal assets from business activity. In other words, only business assets are at risk. LLCs do require registration with the state, usually by filing articles of organization, paying a filing fee, keeping a registered agent [internal link to registered agent page once published] on file and meeting annual reporting requirements.

Nonprofit

A nonprofit can be a corporation or LLC, but must be organized for a charitable purpose, not to recognize a profit or for political or legislative purposes. Most nonprofits are organized under section 501(c)(3) of the Internal Revenue Code, but some states recognize nonprofit LLCs or low-profit LLCs (L3Cs).

Corporation

A corporation (often called a C-corporation or C-corp) is a business structure considered a separate legal entity from its owners for tax and liability purposes. Corporate owners are called “shareholders,” because they are part owners of the company.

Corporations can be “closely-held,” meaning shares of stock in the company are owned by a select group, or “publicly held,” meaning shares are available for purchase to the public. Corporations are created under state law by filing articles of incorporation and meeting other requirements:

• Drafting corporate “bylaws,” which describe business practices, voting rights of shareholders and other necessary information
• Holding annual meetings for shareholders
• Creating a board of directors who have a say in how the company runs
• Filing annual reports with the state of incorporation

Corporations pay a corporate tax to the state, and owners pay personal income tax on their earnings or dividends, known as double taxation. Corporations can have more than one class of stock or no stock at all.

S-Corporation

While its name may be slightly misleading, an S-corporation is not a business structure, it’s a special tax status created by the IRS and named for the IRS code subchapter S which created it. The S-corp status allows the business to be taxed as a pass-through entity, avoiding paying a corporate tax on business income.

Corporations and LLCs can both elect S-corporation status if they meet certain requirements:

• Domestic corporations
• Number of shareholders must be fewer than 100
• Partnerships, other corporations or non-resident shareholders don’t count as shareholders (in other words, shareholders must be U.S. citizens)
• Only one class of stock

Now you know the general rules of corporate tax: both the business and owners are taxed separately. But, that’s not the end of the story. We’ll give you more details about how both of these taxes actually work.

Corporate Income Tax

The federal corporate income tax rate in the U.S. is 21% beginning in 2018. This means that by law, corporations must pay 21% of their taxable income to the government. Corporate income tax rates vary by state. Taxable income is total revenue minus cost of goods sold and other operating expenses. C-corps can deduct expenses to reduce the amount of money subject to the corporate tax rate. C-corps can deduct:

• Employee salaries
• Health benefits
• Tuition reimbursem*nt
• Financial bonuses
• Insurance premiums
• Travel expenses
• Bad debt
• Interest payments
• Sales tax payments
• Fuel taxes
• Excise taxes
• Tax preparation costs
• Legal service fees
• Bookkeeping fees
• Advertising costs

Because of the range of deductions available to a corporation, the effective tax rate — the rate a corporation actually pays — is often much less than the statutory rate.

Owner Personal Income Tax

The income subject to the corporate tax rate is also used to pay dividends to shareholders, who must then pay personal income taxes on the dividends, in the form of state and federal income tax. The federal income tax rate ranges from 10 to 37% depending on income level, and state tax rates vary. Some states, like Tennessee and Texas, don’t have personal income tax rates at all.

Electing to be taxed as an S-corp allows business owners to enjoy tax advantages associated with pass-through entities, but still generally be treated as a corporation. S-corp owners pay themselves a “reasonable salary” out of their taxable income, with the rest either remaining with the company or being distributed as dividends. S-corp owners pay employment taxes on the salaries they pay themselves, but not on the remaining income which is taxed as regular personal income.

Though they also enjoy the benefit of pass-through taxation, S-corps are different from sole proprietorships and LLCs in that the owners don’t pay self-employment taxes.

State-by State

What we’ve covered so far applies at the federal level. States treat S-corps differently, with some states treating them like C-corps and some recognizing their unique status. Most states recognize a company’s federal election to be treated as an S-corp, but Arkansas, New Jersey and New York require companies to file a special S-corp election with the state.

To start a C-corp, you’ll

• Choose a unique name with “Inc.” or “Incorporated” in the name
• File articles of incorporation with the state where you want your business incorporated
• Choose a registered agent as your point of contact in the state of incorporation
• Draft bylaws, create a board of directors and name officers
• Meet annual tax, meeting and reporting requirements

To elect S-corp status, you’ll

• Create either an LLC or C-corp by filing articles with the state
• Meet requirements to elect S-corp status, such as having fewer than 100 shareholders or members
• File IRS form 2553 to elect S-corp status
• Indicate your business has S-corp status on your income tax returns

Legal Disclaimer: This article contains general legal information, but does not constitute professional legal advice for your particular situation and should not be interpreted as creating an attorney-client relationship. If you have legal questions, you should seek the advice of an attorney licensed in your jurisdiction.

Authored by: Laura Jackson, Esq. Laura graduated from Emory University School of Law with her Juris Doctorate and is an active member of the Georgia Bar Association. After several years of appellate advocacy and regulatory experience, Laura turned to full-time freelance legal writing. She currently writes for law firms, websites, and other publications on a range of issues.

Reviewed by: Miranda Riva, J.D. Miranda earned her Juris Doctorate from William & Mary Law School and holds a Tennessee Bar License. Before transitioning to legal content creation, she taught legal research, writing, and citations to first-year law students at two different law schools. In her spare time, you can find Miranda hiking through the U.S. National Parks or spending time at the beach with her two Australian Shepherds.