S-Corp vs. C-Corp: Advantages and Disadvantages of Each for your Palo Alto Business
From the perspective of everybody except the IRS, C-corps and S-corps are very similar; they are “corporations”; and in almost all respects both follow the same rules under corporate law. The IRS rulebook, however, is large and complex, and it enforces quite a few rules in order to separate a “closely held” S-corporation from a “general” C-corporation. For Palo Alto area businesses, there are advantages and disadvantages to each entity structure.
How are C-Corps and S-Corps Similar?
As mentioned above, most of what California S-corps and C-corps do and require under California corporate law is the same; their only difference is a tax difference as defined and determined by the IRS. Thus, both types of entities share the attributes of corporations under California corporate law and, to remind us of the central tenets of such structures, there are a few things that should be mentioned because questions often come up around these issues for forming a new business in the San Francisco Bay Area:
- Legal Separation: Both S- and C-corporations are separate legal entities, meaning that, under most circumstances, shareholders (a.k.a. “owners”) are not personally responsible for a corporation’s debts or liabilities.
- Power Structure: Both S- and C-corporations have shareholders who elect a board of directors that oversees the policy level decision-making processes and steers the company, but who are not tasked with day-to-day operations. That board also elects officers (e.g. CEOs, CFOs, COOs, etc.) who are responsible for the daily affairs of the corporation.
- Legal Obligations: Both types of entities are similarly bound by law to the same basic set of obligations including but not limited to the filing of articles of incorporation, the issuance of stock, the holding and publishing of shareholder and board meetings, the adoption and publishing of bylaws, and the payment of annual fees.
C-Corporations: Unique Advantages and Disadvantages
Taxes: C-corporations are separately-taxed entities, meaning they suffer “double taxation” from a shareholder’s perspective; the corporation’s profits are taxed once as corporate profits, but when they are distributed as dividends, they are taxed again as dividends to the shareholders. On the other hand, any losses are carried forward to apply to the next profitable years’ corporate income, and shareholders’ taxes are unaffected by the loss.
So if a hypothetical Palo Alto C-corp pays a 20% corporate tax rate (the Federal and California combined corporate tax rate is actually much higher, but we will use 20% in this example for simplicity), and their shareholders pay a 20% dividend tax rate, then with $1000 of income, they would end up with $800 after corporate taxes, distributed to 8 shareholders at $100 each, who would in turn pay a 20% tax on the dividend, leaving them with only $80 after paying all taxes.
Salaries: C-corporations can pay their shareholders a reasonable salary if those shareholders perform a function within the corporation. This money is not taxed as corporate profit and is paid directly as income to the salaried shareholder.
Accumulated Earnings: C-corporation profits are only taxed when they are distributed in the form of dividends. Any profit that remains in the corporate coffers for future business expenses is not taxed. Thus, a C-corporation is tax-advantageous when a company is not distributing its income to the owners but rather reinvesting it in things such as capital improvements, increasing capital equipment, research and development, to give just a few examples.
Ownership: A C-corp can be owned by any number of shareholders, and those shareholders may include other corporations, trusts, foreign citizens, and virtually any other individual or legal entity.
Stock Issuance: A C-corp can issue any kind of stock, including common stock (which includes voting rights but does not guarantee a dividend) and any number of types of preferred stock, which can come with a variety of different voting rights, and can offer several options for dividends.
Distribution of Dividends: C-corp entities in the Silicon Valley and throughout California can create and issue stock in a wide variety of ways. However, this does also somewhat limit them, as they are legally bound to distribute dividends precisely according to the dictates of their stock (e.g. each stockholder gets exactly the percentage that their stocks entitled them to and no more or less).
S-Corporations: Unique Advantages and Disadvantages
Taxes: The biggest benefit of an S-corporation is that S-corps “pass through” their profits to their shareholders without paying corporate income tax first. So using the example of the $1000 profit for the Palo Alto corporation referred to above, if they were an S-corp, each of the 8 shareholders would receive a $125 dividend, pay a 20% dividend tax rate and end up with $100 in net income; $20 higher than if they were a C-corp. Losses suffered by the S-corp are also passed through, so if that same corporation lost $800 one year, each of the 8 shareholders would record a $100 loss on their personal income taxes. Also, S-corporations only have to file taxes once annually rather than every quarter.
No Accumulated Earnings: Because all profit and loss is automatically passed-through to the shareholders, there is effectively no such thing as “corporate money,” and any planned business expenses will have to be paid for out of the pockets of the shareholders at the time of the expense.
Ownership: The most significant disadvantage of the S-corporation is that it is limited to a maximum of 100 shareholders, and the shareholders must be individual private American citizens, very specific kinds of estates or trusts, or certain forms of exempt organizations such as a qualified pension plan.
Origin: An S-corp must have been created in, and be based in, the United States of America. Furthermore, an S-corp must start its existence as a C-corp (which occurs by default), then must, by a unanimous decision of all shareholders, elect to take on the form of an S-corp.
Stock Issuance: An S-corp can only issue common stock, meaning that S-corps cannot lure investors in with cumulative, callable, convertible, or other forms of preferred stock that contain attributes certain classes of investor are attracted to.
There are many powerful financial advantages to being a “closely held” S-corporation. But in Silicon Valley, the inability to attract investors by offering shares of preferred stock can put area startups at a disadvantage over their competitors, especially when they need an infusion of capital to take the company to the next level. The right choice of entity for your San Francisco Bay Area business should be determined by your specific needs and goals.
Jeffrey Miller is a Palo Alto business attorney and member of the Palo Alto Area Bar Association (PAABA). He provides skilled guidance on entity selection and all other legal matters for Bay Area businesses. To find out how he can help with your business needs, call attorney Jeff Miller today at (650) 321-0410 or email him at firstname.lastname@example.org.