Shareholders play an important role within a company because they are, after all, part owners. Shareholders have rights and responsibilities, reap benefits, and are exposed to risks—all of which vary depending on the type of corporation. But, we’re getting ahead of ourselves—before jumping into the differences between S corp and C corp shareholders, we first need to define shareholders and private company classifications.
We’ve got you covered; keep reading!
Shareholders own shares of publicly- or privately-held companies, and are typically entitled to voting rights related to certain company decisions. When a company does well, shareholders do well and they may make money; when a company does poorly, shareholders may lose money.
To become a shareholder, an individual, entity, or trust invests their money to buy shares of the company. Business owners who have either founded the company or purchased the company will retain majority ownership of the company and are also shareholders, while shareholders who purchased shares are partial owners. A little confusing, eh? Let’s try an example:
Dina and Tanya started a tech company called Techno X. Dan has invested and purchased shares of Techno X. Dina and Tanya remain the majority owners (and they are also shareholders) and Dan is a partial owner and a shareholder.
Employees at some companies may also own shares of the company’s stock as part of their benefits.
Let’s do a quick refresher: to truly understand shareholder benefits and risks, you must understand different business structures. There are five different types of business entities:
- S corporations (S Corps)
- C corporations (C corps)
- limited liability companies (LLCs)
- sole proprietorships
They all have different taxation rules and shareholder requirements. In addition to these legal entity choices, an LLC or a C corp can make an S corp election to choose to be taxed as an S corp.
S corps and C corps are taxed differently and we’ll get into it below, but before we do, it’s important to understand the difference between two terms: distributions and dividends.
If you thought distributions and dividends were the same thing, you’re not alone. These terms are often confused; they’re both a payment to shareholders based on profit or increase in company value, but S corp payments are called distributions while C corp payments are called dividends.
There is a difference in the way distributions and dividends are reported to the government and there is a difference in how they are taxed.
S corps are pass-through entities. They file 1120-S and report any distributions (not dividends) of profits to shareholders via form K-1. Distributions in excess of basis are taxed. If that sounds confusing, don’t worry; keep reading. We’ll walk you through the basics of basis or you can read about it here.
C corps file taxes via Form 1120 and they report any dividends paid to shareholders via form 1099-DIV. C corp profits are taxed twice because the corporation pays a tax on the profits, and the shareholder who receives dividends also pays taxes on the income they received. For the shareholder, dividends are taxed as capital gains or ordinary income, depending on the type of dividend:
- Ordinary dividends are paid from earnings and profits and taxed as ordinary income
- Qualified dividends are typically taxed at the capital gains rate at the federal level
(Ordinary dividends are taxed just like ordinary income (your salary, for example), while qualified dividends are taxed at the federal capital gains rate.) Note that some states don’t have capital gains or income tax—including Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. This means that shareholders in those states don’t pay state taxes on their qualified dividends. Other states offer tax deductions for certain types of gains that are within state boundaries or meet industry-specific state guidelines. There are also states, like California, that tax all capital gains as income regardless of whether the gains were long or short-term. (Chat with your tax pro if you have shareholder income to understand how your capital gains will be taxed.)
Additionally, when shareholders sell their shares at a profit, they pay federal capital gains tax and applicable state tax, based on how long they’ve owned the shares.
Double taxation is a term many corporate shareholders are familiar with. It refers to two taxes imposed by the IRS: 1) a tax on the company’s earnings, and 2) a tax on the earnings distributed to shareholders as dividends. This is a key difference between S corps and C corps.
S corp shareholders receive a type of pass-through income that’s only taxed once—called a pro-rata share of the company’s income, loss, deductions, and credits, regardless of whether they’ve received distributions of them. However, distributions in excess of basis are taxed. The earnings are passed through to the owners and taxed on their personal income tax return. They’re not subject to self-employment tax. Owners can write off business losses on their personal tax return.
Here’s an example of how it works:
S corps: Let’s say I have an S corp and I sell cake. I gross $100k in cake sales this tax year and I pay myself a salary of $60k. I get a W-2 for that $60k and the cake shop as a business covers part of the payroll taxes (Social Security, Medicare, and unemployment taxes) that come out of gross wages. There’s $40k gross profit left. (Notably, my S corp does not pay any corporate taxes on that $40k profit.)
$100k sales – $60k wages = $40k gross profit
I take that $40k as a shareholder distribution payment and it gets reported on my Form K-1. Distributions in excess of basis are taxed at the capital gains rate (so no payroll taxes). Basis is complex, but in short it’s the cost of your business. Let’s say I invested $20k of my personal funds into the cake shop over the course of the tax year. That’s basis. Also kitchens and cake ingredients aren’t free. Let’s say I have $10k in qualified business expenses (like rent and ingredients). That cost is basis, too. So here’s our rudimentary calculation for taxes:
The $20k personal investment + $10k expenses = $30 in basis
The gross profit distribution ($40k) minus the basis ($30k) = $10k
So, I’ll pay capital gains tax on $10k
C corps: Using the same cake shop example but classifying it as a C corp, my $40k business profit after paying my salary looks a little different. C corps pay corporate taxes (state and federal) on the company’s profit, and then those profits are taxed again when they’re distributed to shareholders as dividends—who pay regular income tax on their ordinary dividends and capital gains tax on their qualified dividends. Dividend payments are reported on Form 1099-DIV. So the cake business is going to pay corporate taxes on the $40k, and if the remainder is distributed to me via a dividend payment, I’ll pay income tax on all of it.
Fine print: not all C corps pay dividends; this info is for those the ones that do.
Another point of differentiation is the tax rate. C corps pay a flat business tax rate at 21 percent, regardless of company size or income, whereas owners of S corps are taxed at the individual rate with the potential for a qualified business income deduction of 20 percent.
S corps can have a maximum of 100 shareholders, and only U.S. citizens or permanent residents can be owners and investors. While there’s only one class of stock, S corps can have voting and nonvoting stock.
In contrast, C corps have zero restrictions on ownership and have multiple classes of stock. There can be an unlimited number of shareholders. Companies looking for funding through investors or expecting high growth potential may benefit from being a C corp, as opposed to an S corp.
While these differences are marked, S corps and C corps share a few similarities:
- Limited liability protection: Shareholders for both entity types aren’t typically responsible for a company’s financial commitments or business debts. In other words, shareholders don’t have to pay out of their personal pockets for the company’s financial obligations.
- Shareholder structure: Both S and C corps elect a board of directors and file annual reports—unless the S corp status stems from an LLC, which may exempt it from needing a board of directors.
These are the basics on what it means to be an S corp and C corp shareholder. Business ownership and shareholder income tend to come with some fine print complexities, so be sure to chat details with your tax pro.