What is the basic difference between a C corporation and an S corporation?

The difference between a regular C corporation and an S corporation is in the way taxes are reported and paid. Both types of corporations are initially formed as a regular C corporation. Both are subject to the same state corporation laws with respect to their organization, operation and the liability of shareholders (S corporations provide the same liability protection to their shareholders as do C corporations).

However, with respect to taxes, the C corporation itself is considered a taxable entity. That means that it files a tax return and pays income taxes on its net income. If the corporation then distributes income in the form of dividends to the shareholders, they are taxed again on the income.

This is often referred to as the double tax of corporations. Most small businesses can avoid or reduce this double tax by paying substantial compensation and providing benefits to the shareholders who work in the business.

Compensation and benefits are generally tax deductible to the corporation as a business expense. If a benefits plan is structured properly, the value of the benefits may not be considered taxable income to the employee.

Compensation must be reasonable or there is the possibility that the IRS could reclassify it as a dividend making it subject to the double tax problem. The other method of avoiding or reducing the double tax is to elect an S corporation status. Unlike a C corporation, an S corporation itself is not a taxable entity.

The S corporation files an informational tax return on form 1120S, but the corporation itself does not pay taxes on the net income of the business. An S corporation is a pass -through entity which means the profits or losses are reported by the owners (shareholders) on their individual tax returns.

An S corporation can also pay compensation to shareholders who work in the business. If the S corporation distributes income to the shareholders, there is no double tax because the S corporation as an entity does not pay any tax. Only the shareholders of the S corporation report and pay income taxes on their prorata share of the business net income.