Quick overview

S Corporations and C Corporations are both corporate forms that provide limited liability to owners, but they differ in how they’re taxed, who can own them, how stock is structured, and how owners receive income. Below I explain the rules, tax implications, common traps, and practical examples I’ve seen in 15+ years advising small businesses.

Sources: IRS — S Corporations and C Corporations (see links below).

How taxation differs (plain language)

  • S Corporation: Income (and losses) generally “pass through” to shareholders. The corporation itself usually does not pay federal income tax. Shareholders report their share of profit or loss on personal tax returns and pay income tax at individual rates. This can reduce or eliminate the classic “double taxation” that C Corps face. S Corps must still file Form 1120-S and issue Schedule K-1s to shareholders (IRS: S Corporations).

  • C Corporation: The corporation pays federal corporate income tax on profits (Form 1120). When after‑tax profits are distributed to shareholders as dividends, shareholders pay tax again on dividends — the double taxation effect. The federal corporate tax rate is a flat 21% under current law (IRS: C Corporations; Form 1120).

Key legal and eligibility differences

  • Ownership: S Corps are limited to 100 shareholders (individuals, certain trusts and estates) who must generally be U.S. citizens or resident aliens. C Corps have no such limits and can include foreign investors, other corporations, and tax‑exempt entities.

  • Stock: S Corps may have only one class of stock (differences in voting rights allowed). C Corps can issue multiple classes (common, preferred) which makes C Corps more attractive for venture capital and private equity.

  • Eligible shareholders and entities: S Corps cannot be owned by C corporations, partnerships, or most nonresident aliens. C Corps have broader ownership options.

  • Elections and forms: To become an S Corp, a corporation (or eligible entity) must timely file Form 2553 with the IRS. C Corps use Form 1120 to report taxable income (see FinHelp links below).

(IRS references: S Corporations; Form 2553; C Corporations; Form 1120.)

Payroll, reasonable compensation, and self‑employment taxes

One of the practical tax benefits of an S Corp is the potential to reduce self‑employment (SE) taxes. Shareholder‑employees must be paid a “reasonable salary” for services performed; that salary is subject to payroll taxes (Social Security and Medicare). Additional profit passed through and paid as distributions is typically not subject to payroll taxes.

In practice, the IRS reviews whether compensation is reasonable using facts and circumstances — job duties, comparable market salaries, hours worked, and company size. Underpaying to avoid payroll taxes risks audits, penalties, and reclassification of distributions as wages.

State taxes, franchise taxes, and other considerations

State treatment varies. Some states impose franchise or entity-level taxes on S Corps and C Corps (e.g., California’s LLC/franchise rules or New York’s filing requirements). Even for S Corps, state taxes or minimum fees can apply. Always check the state taxing authority and consider state filing obligations.

Converting, built‑in gains, and traps

  • Converting C → S: Allowed, but the conversion can trigger tax rules. Of note, if a C corporation had earnings and gains before the S election, a built‑in gains (BIG) tax can apply if appreciated assets are sold within the recognition period. The recognition period was shortened by tax reform; currently consult IRS guidance on the applicable period for your conversion date.

  • Passive income rule: If an S corporation has accumulated C corporation earnings and profits and derives excess passive investment income (generally >25% of gross receipts) for three consecutive years, it may lose S status. This is a technical area; review IRS guidance or ask your CPA.

Practical examples (simplified, hypothetical)

Example A — Small professional service business (S Corp candidate):

  • Pretend net profit before owner pay = $200,000. Owner pays herself a $100,000 reasonable salary (subject to payroll taxes). Remaining $100,000 passes through as distributions and is not subject to payroll taxes. Income is reported on the owner’s Form 1040 through Schedule K‑1 (Form 1120‑S for the entity).

Example B — Venture-backed startup (C Corp candidate):

  • The startup raises capital from investors who require preferred stock and plan to reinvest profits. The C Corp structure allows multiple share classes and non‑U.S. shareholders. Profits retained in the corporation are taxed at the corporate rate (21%) but are not passed through until distributed.

Example C — Conversion tradeoffs:

  • A company that was a C Corp and then elects S status may face tax on built‑in gains when it sells appreciated assets within the recognition period. I’ve advised clients who delayed converting until after asset sales to avoid the BIG tax. In one case, the delay saved a client over $25,000 in avoided recognition of pre‑conversion gain.

These are simplified scenarios; run numbers with your CPA before making structural changes.

When to choose each form — short checklist

Consider an S Corp if:

  • You want pass‑through taxation and reduced double taxation.
  • You can meet shareholder eligibility rules (≤100 eligible shareholders).
  • You can reasonably document and pay a fair salary to owner‑employees.

Consider a C Corp if:

  • You need to attract outside capital, issue preferred shares, or accept nonresident investors.
  • You plan to retain and reinvest earnings at the corporate level.
  • You expect significant corporate growth and may seek an acquisition or IPO.

Common mistakes I see in practice

  • Treating owner distributions as a substitute for reasonable salary to avoid payroll taxes. The IRS scrutinizes this.
  • Ignoring state entity taxes or filing requirements when choosing S status.
  • Not considering the built‑in gains rules when converting C→S.
  • Failing to plan for fringe benefits: Certain employee benefits (health, retirement) may be treated differently between S and C corporations.

How to evaluate the tax impact (step‑by‑step)

  1. Project business taxable income for 3–5 years.
  2. Estimate owner compensation vs. distributions and payroll taxes for S Corp.
  3. Model corporate tax at 21% and potential dividend tax for C Corp distributions.
  4. Add state taxes, franchise taxes, and compliance costs.
  5. Factor in capital‑raising needs (will investors require multiple stock classes?).
  6. Run sensitivity tests: what happens if profit grows faster or slower than expected?

I often run a side‑by‑side tax projection for clients to quantify the break‑even point where one form beats the other.

Final tips from my practice

  • Document how you determined “reasonable compensation” — use industry salary surveys, job descriptions, and minutes from board or shareholder meetings.
  • Revisit entity choice after major events: new investors, large asset sales, or a material change in revenue.
  • Work with a CPA or tax attorney to prepare the S election (Form 2553) and to analyze conversion timing if you’re moving from C to S.

Professional disclaimer: This article is educational and not a substitute for personalized tax or legal advice. Tax rules and rates change; consult your CPA or tax attorney for advice tailored to your facts and the latest law.