What is a C corporation? What is an S corporation?

What is a C Corporation? What is an S Corporation?

These are really two different questions, of course. But because the questions and answers are closely related, I want to cover the questions together.

Answering the "C corporation" question

To start, let me answer the "what is a C corporation" question: A C corporation is a corporation that's subject to income taxes on its profits. In other words, if a C corporation makes $100,000 in profit, the C corporation pays income taxes on the $100,000. And that fact--the corporation paying its own taxes on its own income--is the distinguishing feature of a C corporation.

Note: If the after-tax profits of the C corporation are paid out to corporation shareholders as dividends, those shareholders get taxed again on the dividends. This second tax on the dividends is the double tax you sometimes hear people talk (complain) about.

Answering the "S Corporation question

Now, let me answer the "what is an S corporation" question: An S corporation is a corporation that's not typically subject to income taxes on its profits. Rather, the S corporation allocates its income to its shareholder and they then pay the income taxes on the profits. For example, if an S corporation makes $100,000 and has two equal shareholders named Smith and Jones, the S corporation doesn't pay income taxes on its profits. Rather, Smith pays the income taxes on $50,000 of the profits. And Jones pays the income taxes on other $50,000 of profits.

Further Differences Between S Corps and C Corps

Now that you understand the basic difference between a C corporation and an S corporation, let me share some clarifying comments about C and S corporations:

1. C corporations and S corporations aren't "real" corporations. C and S corporations are tax accounting concepts. A C corporation is actually just an entity that's taxed according to Subchapter C of the Internal Revenue Code. And an S corporation is just an entity that's taxed according to Subchapter S of the Internal Revenue Code. This is a really important distinction to make because other entities such as limited liability companies can also be treated as C and S corporations. (LLCs do this by filing election paperwork with the IRS.) And some entities that aren't even incorporated (like an association for homeowners) can be treated as C corporations in certain circumstances.

2. By default, a corporation you create by filing articles of incorporation with the state gets treated as a C corporation. That means that by default, a corporation pays its own income taxes.

3. In order to convert a C corporation to an S corporation, you file a Subchapter S election with the IRS using a form 2553 (which is available at the IRS web site, irs.gov.)

4. Any corporation can be a C corporation, but a corporation must meet a handful of eligibility requirements in order to be an S corporation. An S corporation can have only one class of stock, for example. And an S corporation can only have US citizens or permanent residents as shareholders as another example. Finally, an S corporation is limited (sort of) in the number of shareholders it can have.

5. Small C corporations--and this is a bit awkward to say--small C corporations often don't actually pay income taxes. Often, seemingly by magic, the small C corporation pays out all of its profit to shareholder-employees in the form of wages. This "no profits but lots of wages" situation means that the small C corporation often doesn't pay income taxes but does pay heavy payroll taxes.

6. S corporations--and here I make another awkward comment--save taxes for their shareholder-employees when they set modest wages for shareholder-employees. (I talk more about this on C Corp versus S corporation page.) As of the writing of this article, Congress is trying to close this loophole starting in 2011 for small professional service corporations.

7. S corporations can in fact pay income taxes in some circumstances. When this happens is beyond the scope of this short article, but in general, only three types of S corporations have to pay income taxes: S corporations that have previously been C corporations get subjected to federal income tax in special cases, big S corporations in the state of Massachusetts can be subjected to state income taxes, and Tennessee S corporations can be subjected to state income tax because Tennessee state laws just plain don't recognize S corporation status.

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