C corporations and S corporations are similar in some ways. Both limit the financial liability of owners, give total authority to shareholders and require a business filing. However, there are significant differences in how the corporations are taxed and how the ownership can be structured. Depending on the income level and types of shareholders in the business, one form may be preferable over another.
C Corporation Taxation
The most significant difference between a C corp and an S corp is the method of taxation. A C corporation is a distinct taxable entity. That means the corporation itself pays taxes on its net income. If shareholders want to get money out of a C corp, it must be done by issuing dividends. The main drawback of C corp taxation is that these dividends are taxed twice. Since dividends are paid out of retained earnings, the C corporation doesn't get a tax deduction for them. After distributing the dividends, the shareholder has to pay taxes on the dividends at the individual level.
S Corporation Taxation
Unlike C corps, S corporations are not subject to double taxation. That's because S corps are a pass-through entity rather than a separate taxable entity. Although the owners still must file a tax return for the S corporation, the company itself doesn't pay income taxes. Instead, all gains and losses pass through to the shareholders. The individual shareholders then pay any tax due when they file their annual tax returns.
While C corporations get the short end of the stick when it comes to taxes, they offer much more flexibility in terms of ownership structure. C corporations have basically no restriction regarding ownership. The company can have as many shareholders at it pleases, and of any nationality. In contrast, S corporations are only allowed a maximum of 100 shareholders and all shareholders must be U.S. citizens or residents. Other business entities -- C corps, S corps, LLCs and partnerships -- can be shareholders of a C corporation, but all S corporation shareholders must be individuals. Finally, C corporations can create multiple classes of stock whereas S corporations can only have one.
C corporations and S corporations are not necessarily stuck in their current legal forms forever. A C corporation can switch to an S corporation by electing to do so in its tax return. The election can be made on Form 2553 and all shareholders must agree to the election. A S corporation can switch back to a C corporation, but it must wait five years before it can convert back. If it converts back sooner, the company may have to pay additional income taxes related to the switch.
Based in San Diego, Calif., Madison Garcia is a writer specializing in business topics. Garcia received her Master of Science in accountancy from San Diego State University.