Business owners who want to incorporate can choose between forming a C-Corporation or an S-Corporation. Both offer liability protection, but they handle profits differently.
A major difference comes from how each treats retained earnings. These differences can affect how a company reinvests in growth or expansion.
Tax treatment of retained earnings
C-Corporations in Texas pay federal corporate income tax on their profits, including retained earnings. The company keeps these profits to reinvest in the business instead of distributing them to shareholders.
If the company distributes those retained earnings as dividends after paying corporate taxes, shareholders must pay personal income tax on that amount. This setup creates what many call “double taxation.”
In contrast, S-Corporations do not pay federal income tax at the corporate level. Instead, they pass profits and losses to their shareholders, who report them on their personal tax returns. Even if the business retains earnings and does not distribute them, shareholders must still pay tax on their share of the profits.
Reinvestment strategies and impact
C-Corporations in Texas can reinvest retained earnings without needing to distribute those funds to shareholders. This setup allows them to keep more capital in the business for equipment, staffing, or expansion.
Since shareholders only pay taxes when the company issues dividends, C-Corps can focus on long-term growth without pressuring owners to pull money from the company too soon. Additionally, C-Corps often attract investors more easily and provide greater flexibility when structuring acquisitions. These advantages may minimize the issue of double taxation.
S-Corporations face more limitations when it comes to reinvestment. Even though the company keeps the earnings, shareholders still owe tax. That tax bill may lead some shareholders to request actual distributions to cover the cost, which can reduce the amount left for reinvestment.
The tax structure can influence how quickly and aggressively an S-Corp grows. However, the potential tax savings can make this structure preferable for smaller companies that don’t anticipate rapid growth.
Understanding how retained earnings work helps business owners in Texas choose the right structure. Each structure offers benefits, but owners must consider how taxes affect their growth plans and cash flow.
