S-Corp vs. C-Corp: A Guide to Corporate Tax Classifications

October 25, 2022

Yin Wu

One of the first steps in incorporating your startup is choosing which legal business structure to go with. The good news is that most startups end up selecting from a fairly narrow list of options. We’ve talked elsewhere about the relative pros and cons of incorporating as an LLC (limited liability company), which can make sense for small business owners with modest ambitions. But for startups of a certain size and growth trajectory, it likely makes sense to go with one of two types of corporation: an S-corporation or a C-corporation.

That’s right—the fun doesn’t stop once you’ve chosen a basic business structure. C-corp and S-corp are two different types of corporations for tax purposes. Your corporation will remain a C-corp by default if you don’t qualify and submit the forms required for S-corp status, but that isn’t necessarily a bad thing. While S-corp status may come with significant tax advantages, a C-corp has a clear advantage in raising money from venture capital firms and other investors.

In this guide, we’ll break down the key differences between S-corps and C-corps. But let’s define some terms before we get too far ahead of ourselves.

S-corp vs. C-corp: At-a-glance comparison

• What is a corporation?
• S-corp vs. C-corp: How are they different?
• Should I form an S-corp or C-corp?
• Pulley makes sense for startups of all sizes

What is a corporation?

A corporation is a legal entity that is separate and distinct from its shareholders, directors, and officers.

The word “corporation” originates in the Latin word corpus, which means “body.” This is both an oddity and oddly significant, because in the eyes of the law a corporation essentially acts as its own distinct person. A corporation may not have hands and feet, but it does have certain rights that you may think of as belonging to a person. For example, a corporation can lend, borrow, and sue other corporations (or people, for that matter).

Crucially, a corporation also protects its owners from personal liability. This means that the business owners are generally not personally liable for any debts or obligations belonging to the corporation. Other business structures may offer a similar degree of limited liability protection, but corporations offer some of the strongest personal liability protection of any business structure.

As with actual people, corporations can be a little complicated. They must have corporate bylaws, conduct annual meetings, elect a board of directors, and adhere to strict record-keeping regulations. And though they’re mostly governed by state law, corporations must also stay in line with certain federal regulations.

S-corp vs. C-corp: How are they different?

The primary distinction between an S-corp and a C-corp lies in how each is treated for tax purposes. As we noted above, corporations are C-corps by default. A corporation can apply with the IRS for S-corp status if it meets certain requirements, but why would it want to do so? To answer that question, let’s take a look at how each type of corporation is taxed:

• A C-corp is taxed separately from its owners. This can lead to an issue known as “double taxation,” because a corporation must pay corporate income tax on its earnings, and its shareholders must also pay taxes on dividends distributed at the individual level. This means that dividends are “double” taxed—once at the corporate level, and once at the individual level.
• An S-corp passes through corporate income, losses, deductions, and credits to its shareholders for federal tax purposes. This circumvents the double taxation issue, because the corporation does not pay corporate income tax on its corporate income. Instead, the corporation’s shareholders report the passed-through income and losses on their personal tax returns, where it is taxed at their personal income tax rates.

Reading the above, you might be wondering why every corporation doesn’t just choose S-corporation status and get on with their day. Paying taxes once is awful enough—who would sign up to do it twice if there’s an alternative?

Well, it’s not so simple as all that. There are some other key differences in how S-corps and C-corps function, and a corporation must carefully consider these before deciding to go with one versus the other. Let’s take a look at how these corporation types differ in terms of formation as well as ownership and equity.

S-corp vs. C-corp: Differences in formation

Whether you’re setting up an S-corp or a C-corp, the first part of the process typically looks the same. You’ll need to file articles of incorporation with the state agency that oversees corporate filing. You’ll also need to create a set of corporate bylaws, find a registered agent if your state requires one, elect a board of directors, hold board and shareholders’ meetings, and issue your first shares of stock.

Assuming you’ve taken care of all this, you now have a corporation. More specifically, you have a C-corporation.

Forming an S-corp requires some additional legwork. Before you put in that legwork, you should verify that your corporation actually meets the requirements to qualify for S-corporation status. Subchapter S of the U.S. Internal Revenue Code specifies that a corporation must meet the following requirements for S-corp status:

• It must be incorporated and operating within the U.S.
• It must have only allowable shareholders (i.e. U.S. citizens, certain trusts, and estates)
• It must have 100 or fewer shareholders
• It must have only one class of stock
• It must not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

If your corporation meets those requirements, you can file for S-corp status by filling out and submitting IRS Form 2553, Election by a Small Business Corporation. Note that this form must be signed by all of the corporation’s shareholders.

S-corp vs. C-corp: Differences in ownership and equity

If you read the above requirements carefully, you will see that an S-corp faces certain limitations and restrictions that fundamentally distinguish it from a C-corp. These limitations may not be such a big deal for a startup of a certain size, but they can severely hamper a growing startup’s ability to raise money from investors.

For example, an S-corporation can only issue one class of stock. This creates a potential problem, as many corporations find it strategically beneficial to issue different classes of stock to investors and employees. Investors are typically offered convertible preferred stock, while employees are typically offered common stock at a relatively inexpensive price as an equity incentive. Not being able to offer preferred stock (with its attendant rights) to investors can be a big problem for a corporation that wants to attract outside investment.

Other restrictions in ownership can also hinder an S-corp’s ability to grow. Restrictions on the number of shareholders and type of shareholders (i.e. no foreign citizen allowed) limit the pool of potential investors. A C-corp thus has a distinct advantage when it comes to attracting venture capital.

Should I form an S-corp or a C-corp?

Whether you decide to form an S-corp or a C-corp depends on a lot more than potential tax savings. Here are some questions that may help you arrive at the best answer for your situation:

• Do you plan to aggressively court new investors? If so, a C-corp could make more sense for you. More specifically, you’ll want to look into starting a Delaware C-corp, which venture capital investors highly prefer to any other business entity. If you smell a funding round in the future, a Delaware C-corp is likely your best (and maybe your only) choice.
• Do you plan to sell stock globally? If not, then the fact that an S-corp is limited to U.S. citizens and resident alien shareholders probably doesn’t matter to you.
• Do you plan to offer benefits to shareholders who are employees? C-corps may be able to deduct some employee benefits, such as health insurance and life insurance, so long as the benefits are provided to a certain percentage of employees. S-corps don’t have this advantage, and the cost of benefits may be taxable to shareholders.
• Is there some other type of business structure that makes even more sense? We haven’t discussed any other business structures, such as sole proprietorships and limited partnerships, because these typically aren’t suitable to high-growth startups. But they could make sense for your situation, and it pays to research all the possibilities before categorically ruling any out.

Pulley makes sense for startups of all sizes

Whether you’re just getting off the ground or preparing for your next funding round, Pulley is here to help. We have plans that scale alongside your business and offer everything you need to manage your cap table along the way, from fundraising modeling tools to audit-ready 409A valuations.

You can onboard to Pulley in just five days, but you’ll benefit from our tools and expertise for the rest of your startup journey. Schedule a call with one of our experts today, and let us show you how we can help you take your startup to the next level (and beyond).