Subject: Bill and Darlene plan to go into business together. They anticipate losses in the first two or three years, which they would like to use to offset income from other sources. They also are concerned about exposing their personal assets to business liabilities. Write a short paper advising Bill and Darlene what business form you would recommend for them as they start up their business. State any assumptions you make. For additional details, please refer to the Short Paper/Case Study Rubric document in the Assignment Guidelines and Rubrics section of the course.

Short paper.

Since Bill and Darlene are planning to go to business together, I will advise them to focus on S corporation.

What is C Corporation?

By forming a C Corporation, business owners create a separate legal structure that helps shield their personal assets from judgments against the company. C Corporations have a specific structure that includes shareholders, directors, and officers.

The C Corporation is a time-tested business formation. It has many advantages, including:

Limited liability for directors, officers, shareholders, and employees

Perpetual existence, even if the owner leaves the company

Enhanced credibility among suppliers and lenders

Unlimited growth potential through the sale of stock

No limit on the number of shareholders, although once the company has $10 million in assets and 500 shareholders, it is required to register with the SEC under the Securities Exchange Act of 1934

Certain tax advantages, including tax-deductible business expenses

The C Corporation structure does have its drawbacks. For instance, a C Corporation's profits are taxed when earned and taxed again when distributed as shareholders' dividends, what's known as "double taxation." Shareholders in a C Corporation also can't deduct any corporate losses. To avoid these concerns, many small business owners choose to form an S Corporation instead.

What is S corporation?

S Corporation are corporations that elect to pass corporate income, losses, deductions and credits through the shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.

What are the quality of S corporation and the following requirement the corporation must meet?

The corporation must be domestic.

Have only allowable shareholders, which may be individual, certain trust, and estates and may not be partnerships, corporations or non-resident alien shareholders.

Have no more than 100 shareholders, have only one class of stock.

Not be an ineligible corporation such as certain financial institutions, insurance companies and domestic international states corporation.

S corporation vs. C Corporation: The similarities

The C Corporation is the standard corporation, while the S corporation has elected a special tax status with the IRS. It gets its name because it is defined in Subchapter S of the Internal Revenue Code. To elect S corporation status when forming a corporation, Form 2553 must be filed with the IRS and all S corporation guidelines met. But C corporations and S corporations share many qualities:

Limited liability protection. Both offer limited liability protection, so shareholders (owners) are typically not personally responsible for business debts and liabilities.

Separate entities. Both the S corporation and C Corporation are separate legal entities created by a state filing.

Filing documents. Formation documents must be filed with the state. These documents, typically called the Articles of Incorporation or Certificate of Incorporation, are the same for both C and S corporations.

Structure. Both have shareholders, directors and officers. Shareholders are the owners of the company and elect the board of directors, who in turn oversee and direct corporation affairs and decision-making but are not responsible for day-to-day operations. The directors elect the officers to manage daily business affairs.

Corporate formalities. Both are required to follow the same internal and external corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder and director meetings, filing annual reports, and paying annual fees.

S corporation vs. C Corporation: The differences

Despite their many similarities, S corporations and C corporations also have distinct differences.

Taxation. Taxation is often considered the most significant difference for small business owners when evaluating S corporations vs. C corporations.

C corporations. C corps are separately taxable entities. They file a corporate tax return (Form 1120) and pay taxes at the corporate level. They also face the possibility of double taxation if corporate income is distributed to business owners as dividends, which are considered personal income. Tax on corporate income is paid first at the corporate level and again at the individual level on dividends.

S corporations. S corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no income tax is paid at the corporate level. The profits/losses of the business are instead passed-through the business and reported on the owners personal tax returns. Any tax due is paid at the individual level by the owners.

Personal Income Taxes. With both types of corporations, personal income tax is due both on any salary drawn from the corporation and from any dividends received from the corporation.

Corporate ownership. C corporations have no restrictions on ownership, but S corporations do. S corps are restricted to no more than 100 shareholders, and shareholders must be US citizens/residents. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. Also, S corporations can have only one class of stock (disregarding voting rights), while C corporations can have multiple classes. C corporations therefore provide a little more flexibility when starting a business if you plan to grow, expand the ownership or sell your corporation.

S corporation election

To become an S corporation, you must file Form 2553 with the IRS. The IRS instructionswhich can be a bit tough to followrequire that an election is considered effective in the current tax year only if the Form 2553 is completed and filed:

Any time before the 16th day of the 3rd month (for calendar year tax payers, this means it needs to happen by March 15th)

Any time during the preceding tax year (however, an election made no later than 2 months and 15 days after the beginning of a tax year that is less than 2 months long is treated as timely for that year).

Generally, an election made after the 15th day of the 3rd month but before the end of the tax year is effective for the next tax year (unless you can show failure to file on time was due to reasonable cause).

Keep in mind that some states also require you to file a state-level S corporation election after incorporating your business.