Differences between C and S Corporations for a Small Business - dummies

Differences between C and S Corporations for a Small Business

By Richard D. Harroch

Part of Small Business Kit For Dummies Cheat Sheet

A corporation is a separate legal entity formed under a state corporation law. Your small business can register as a C corporation or an S corporation if you go the corporation route, which you may want to do to shield shareholders from the corporation’s debts and liabilities.

The following key points characterize C corporations:

  • Limited liability: Generally, the shareholders, officers, and directors of the corporation aren’t personally liable for the corporation’s debts and liabilities.

  • Perpetual existence: In contrast to partnerships and sole proprietorships, corporations generally can last forever unless they’re voluntarily dissolved.

  • Control and management: A corporation’s overall management is vested in the board of directors chosen by the shareholders. The board of directors elects the corporation’s officers, who handle the business’s day-to-day affairs under the board’s general direction.

  • Shareholders’ rights: Shareholders typically have various rights, including the right to elect directors, receive information, inspect corporate records, vote on fundamental business decisions (such as mergers and liquidations), and share in distributions.

  • Owners and profits: The owners of the corporation are the shareholders who have received stock in the corporation.

  • Corporate formalities: You should observe various corporate formalities, such as maintenance of separate books, records, and accounts; completion of various governmental filings; and periodic meetings or written consents of directors and shareholders.

  • Stock transferability: Stock certificates are signs of ownership. Their transfer may be restricted; for example, the corporation may have a right of first refusal on transfer. And federal or state securities laws can limit stock transfers.

  • Capital formation: The corporate entity accommodates a wide variety of forms of capitalization, such as common stock, preferred stock, stock options, warrants, and convertible securities.

  • Employee stock ownership: Corporations provide the best vehicle to give employees equity interests in the business. Corporations allow tax-advantaged stock option grants, which aren’t available for other entities.

  • Tax: C corporations are taxed at the corporate level. The government taxes most dividends as income to the stockholders.

An S corporation is a regular corporation, but the business’s income passes through to the shareholders, and the shareholders pay income taxes based on their portion of the corporate income. In order to become an S corporation, you must follow a number of key rules, including

  • IRS election: All shareholders must sign and file IRS Form 2553 with the IRS. You may also need to make an election with your state of incorporation. New corporations must file the IRS form by the 15th day of the third month of your tax year (basically, a 2 1/2 month window).

  • Number of shareholders: An S corporation can have no more than 75 shareholders.

  • One class of stock: An S corporation can only have one class of stock, although certain differences can exist in voting rights among the shareholders.

  • Restrictions on the type of shareholders: Generally, corporations, various trusts, and nonresident aliens may not be shareholders in an S corporation.

If you want investors for your small business, you need to write a business plan so that you have something to present to bankers and potential investors. The format of every good business plan, although not set in stone, tends to run along the same basic lines — it shouldn’t have anything that surprises investors.

The business plan format is fairly standardized, typically containing the following key sections:

  • Cover page: Contains contact information and a statement that the plan is deemed confidential

  • Table of contents: Enables your readers to quickly find the exact information they’re looking for

  • Executive summary: Explains, briefly, your business’s prospects, needs, and situation

  • Company description: Contains a historical account of the company, as well as its future prospects

  • The product or service: Explains what is unique about the products or services that your business plans to deliver

  • The market: Creates a picture of the market in which your business competes

  • Marketing: Informs your reader of how you plan to capture your business’s potential market (packaging, distribution, advertising, Web marketing, and so on)

  • Management/ownership: Introduces the people holding leadership positions in the business, their relevant experience and credentials

  • Competition: Focuses on your competitors’ strengths and weaknesses

  • Financial statements and projections: Includes a lot of numbers (hopefully black), like your balance sheet, income statement, cash flow statement, and financial forecasts

  • Appendices: Contains résumés of key personnel, an organizational chart with positions and responsibilities, extended market information, and other data to back up the claims in your business plan