Michigan Business Lawyer Blog

Usually the most important factors that go into a business owner's decision to incorporate have nothing to do with tax issues. Rather, most business people incorporate because they want to shield personal assets from trade creditors and litigation. (Corporate stockholders, unlike sole proprietors, are not personally liable for business obligations.)

However, once the decision to incorporate is made, the next decision that must be made is whether to set up the corporation as a C corporation or an S corporation. The "C" and "S" refer to subchapters in the IRS code that govern each corporation. There are big differences in tax treatment of C corporations and S corporations.

S corporations are pass-through entities. In other words, there is no corporate income tax on an S corporation. Instead, the profits flow through to the shareholders who are taxed at their personal income tax rates on corporate profits. In addition, S corporations allow active shareholders tax advantages such as sharing in operating losses, which are common in business start-ups.

But, while S corporations are terrific for many small businesses, they are not for everyone. There are a number of possible operational and tax disadvantages to S corporations. Potential operational disadvantages include limits on the number of shareholders, limits on the types of shareholders, and the requirement of having only one class of stock. Possible tax disadvantages include immediate taxation of earnings (the downside of pass-through entities) and limited employee fringe benefits.

Depending on a business's operations and structure, a C corporation may be a better choice than an S corporation. Generally speaking, most of the "heavy hitters" out in the business world are C corporations. The reason is that C corporations allow for the widest variety of tax-advantaged fringe benefits. There is usually more flexibility in the capital structure of a C corporation, which can also be an advantage over an S corporation. Some of the tax advantages of C corporations include the ability to retain earnings for future growth, income splitting possibilities, increased options for fringe benefits, enhanced ability to claim operating losses (on the corporate level only), tax breaks on dividends received from other companies, and the ability to claim charitable deductions, which other business entities can't. Typically, once a company's annual net income exceeds $100,000, it should seriously consider becoming a C corporation if it isn't already.