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October 06 2013

A Tax Course Refresher: The Taxation of C Corporations & S Corporations

posted by Melvin Frederickson

When deciding to form a corporation, business owners have to determine which form of organization best meets their business goals and objectives. There are certain advantages as well as disadvantages associated with the different types of organizations available. The ease in which the corporation is established is another factor to consider when forming a business.

Understanding how different types of business organizations are taxed can help a business decide which route to take. The following is a discussion of the tax treatment of two specific types of corporations: S Corporations and C Corporations. Understanding the difference between these two forms is important for a business owner.

S Corporations versus C Corporations   

In the 1970s and 1980s, limited partnerships were a popular form of business organization. They differed from the more traditional general partnership since they provided a liability shield to those partners who were not actively involved in the management of the business. In a limited partnership, there could be an unlimited number of limited partners associated with the business, which was managed by a general partner. If the business failed or dissolved, any claims by creditors would be limited to the ownership percentage of the partner and no more.

This concept was carried over into a new hybrid corporation form known as the Subchapter S or S Corporation. Small businesses in particular benefitted by being able to establish themselves as S Corporations, through an elective filing with the Internal Revenue Service (IRS). As long as the corporation has no more than 100 shareholders who are U.S. citizens or resident aliens and an established calendar fiscal year for accounting purposes, the business may elect to be an S Corporation. This was important for a small business because it allowed the business to assign losses to shareholders individually on a pro-rata basis (important if such losses are considered passive losses) and avoid the taxation of assets sold by the business.

Advantage of the C Corporations Business Form   

When filing their articles of incorporation in the state where they are located (domiciled), all corporations are classified as C Corporations. Through the filing of the one-page Form 2553, the S Corporation is recognized by the IRS. For businesses that meet the criteria of an S Corporation (mainly small businesses) the S Corporation offers the greatest amount of flexibility.

A business that seeks the capital markets for additional funding ("going public") must form as a C Corporation. The clear advantage with this business form is the ability to exceed the 100 shareholder limit imposed on S Corporations, and the opportunity to accept other types of large "institutional" investors.

How S and C Corporations are Taxed   

C Corporations are taxed at a corporate tax rate of 39 percent under current tax law (including weighted state corporate tax rates). They are also taxed on the sale of assets from the business, resulting in a double taxation. For S Corporations the tax rate is based on the individual tax rate of the shareholders. Although S Corporation shareholders receive the protection of their assets upon dissolution, gains, losses, and credits, and deductions are passed through the corporation and reported on the returns of the individual shareholders.

Forming an S Corporation may make sense for a business that looks to become public at some future point. Tax law permits S Corporations to elect C Corporation status by receiving approval from shareholders and notifying the IRS by letter.

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Melvin Frederickson

About the Author: Melvin Frederickson
melvin@lsj.com

Melvin Frederickson is a freelance legal blogger and writer who routinely contributes articles on Tax Law, Financial Regulation, Banking Law, Bankruptcy, Contract Law, Commercial Paper and other related areas; those interested in joining the world of finance should view the financial analyst jobs with moneyjobs.com.

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