Overview

S Corporation vs. C Corporation is primarily a tax distinction, not a different legal form. Both S Corps and C Corps are corporations for state-law purposes, but they differ in how the IRS taxes income and how shareholders are treated for payroll and distributions. This article explains the tax mechanics, eligibility rules, practical consequences, and key decision points to help U.S. business owners choose the right structure.

Key tax differences — at a glance

  • Pass-through vs. entity tax: S Corporations are pass-through entities for federal income-tax purposes; profits and losses flow through to shareholders and are reported on their individual returns. C Corporations are taxed at the corporate level and again when profits are distributed as dividends to shareholders (double taxation).
  • Corporate tax rate: C Corporations pay federal corporate income tax (the flat 21% rate established by the Tax Cuts and Jobs Act remains in effect federally); state corporate taxes vary by state. S Corporation income is taxed at shareholders’ individual rates.
  • Payroll and self-employment taxes: Shareholder-employees of an S Corp must receive “reasonable compensation” as wages subject to payroll taxes; remaining distributions are typically not subject to payroll or self-employment tax. Owners of C Corps who are also employees receive wages subject to payroll taxes; dividends are not subject to payroll taxes but are taxed as investment income.
  • Reporting forms: C Corps file Form 1120; S Corps file Form 1120-S and issue Schedule K-1 to shareholders.

(Authoritative overview from the IRS: S Corporations and Forms 1120 / 1120-S.)

How the tax mechanics affect cash and planning

  • Double taxation example (simplified): A C Corp earns $100, pays $21 in federal tax (21%), leaving $79. If it distributes $79 as a dividend, shareholders pay tax on that dividend at their individual dividend rate — producing an overall higher combined tax burden than pass-through treatment.

  • S Corp pass-through and payroll strategy: An S Corp with net profits passes those profits to shareholders who pay tax on their share. However, the IRS requires shareholder-employees to receive reasonable wages for services provided. In practice, owners often balance salary (payroll-tax subject) and distributions (not payroll-tax subject) to reduce overall employment taxes — but compensation must be defensible in case of audit (see IRS guidance on reasonable compensation).

Eligibility, ownership limits and stock rules

  • S Corporation limits: Up to 100 shareholders (families may be treated as one under certain rules), shareholders generally must be U.S. citizens or resident aliens, and eligible shareholders include individuals, certain trusts, and estates. S Corps may only issue one class of stock (differences in voting rights are allowed so long as economic rights remain the same). Corporations, partnerships and nonresident aliens generally cannot be S shareholders (IRS – S Corporations).

  • C Corporation flexibility: C Corps can have unlimited shareholders, multiple classes of stock, and foreign or institutional investors — a key reason many venture-backed startups and businesses seeking broad capital will choose C Corp status.

Converting and traps to watch for

  • Converting C → S: A C Corporation can elect S status by filing Form 2553, but conversion may trigger tax consequences. For example, the built-in gains (BIG) tax can apply to appreciated assets sold within a statutory recognition period following conversion; corporate tax attributes and year-end closing issues can complicate the transition. (See Form 2553 guidance and pitfalls.)

  • S → C: An S Corp can revoke its S election, but timing matters for corporate tax years and accumulated earnings and profits. Shareholders should model the tax impact before changing status.

State taxes and other considerations

  • State variation: Some states don’t recognize S status or impose entity-level taxes on S Corps or impose franchise taxes and fees that change the economics. Always check your state’s rules.

  • Qualified Business Income (QBI) and deductions: Pass-through owners may be eligible for Section 199A QBI deductions subject to complex rules and income phases. The availability and benefit of QBI can change whether pass-through treatment yields an advantage.

Compliance and year‑end differences

  • Forms and schedules: C Corps file Form 1120 and report dividends on Form 1099-DIV to shareholders. S Corps file Form 1120-S and prepare Schedule K-1 for each shareholder to report allocated income, losses, and credits.

  • Payroll and estimated taxes: Shareholder-employees of S Corps must run payroll for wages. Owners must plan quarterly estimated taxes for pass-through income if insufficient withholding exists. C Corps make corporate estimated tax payments.

When to choose each structure — practical decision checklist

  1. Capital needs: If you plan to raise venture capital or issue multiple classes of stock, C Corporation is typically more compatible with investor expectations.
  2. Short-term owner income: If profits are regularly distributed to owners and you want to avoid corporate-level tax, S Corp may be preferable.
  3. Growth and reinvestment: If you intend to retain earnings within the company to fund growth, a C Corp can offer lower corporate-level tax on retained earnings and flexibility for equity incentives.
  4. Ownership type: Nonresident shareholders, corporate investors, or large employee stock plans usually rule out S election.
  5. Payroll optimization vs. audit risk: While S Corps can reduce self-employment tax through distributions, you must document and justify reasonable compensation.

In my practice advising small businesses and startups, I’ve seen owners switch wrong-sided because they didn’t model cash flow after taxes, payroll obligations, and state fees. Run multiple scenarios — including conservative reasonable-compensation assumptions — before electing S status.

Practical steps to decide and implement

  • Step 1: Run a 3–5 year tax projection modeling net income, distributions, salaries, and retained earnings under both structures.
  • Step 2: Evaluate investor plans and hiring equity-insensitive investors early; talk to potential investors about preferred structures.
  • Step 3: Consult a CPA and business attorney to confirm state compliance, payroll setup, and corporate governance impacts.
  • Step 4: If electing S status, file Form 2553 timely (see common pitfalls and guidance on Form 2553). If you form a new corporation and want S status from day one, file within the IRS timing window.

Helpful internal resources: FinHelp’s guide to S Corporation basics and the C Corporation taxation overview can help with mechanics and filing requirements:

Common mistakes and misunderstandings

  • Treating distributions as “salary” avoidance: Underpaying yourself relative to reasonable compensation can trigger IRS scrutiny and reclassification of distributions into wages, with back payroll taxes and penalties.
  • Ignoring state / franchise taxes: State rules can substantially change the effective tax cost of an S election.
  • Assuming pass-through is always cheaper: High-income owners might pay more on pass-through income depending on personal rates, the availability of QBI, and state taxes.

Quick FAQs

  • Can a C Corp convert to an S Corp? Yes, with Form 2553 and shareholder consent, but conversion can trigger built-in gains tax and other adjustments.
  • Does an S Corp avoid payroll taxes entirely? No — shareholder-employees must receive reasonable wages subject to payroll taxes; only distributions beyond reasonable wages generally avoid payroll taxes.
  • Is S Corp status permanent? It can be lost for violations (e.g., ineligible shareholder), and shareholders can revoke the election; both have timing and tax consequences.

Professional tips

  • Document the methodology you used to determine reasonable compensation and update it annually.
  • Model both taxable income and cash flow after payroll and estimated taxes.
  • If you plan to take on investors, get their input early — converting later can be costly.
  • Keep corporate minutes and formalities to preserve limited liability protection.

Sources and further reading

Disclaimer

This article is educational and does not substitute for personalized tax or legal advice. Tax law changes and state rules affect which structure is best for your situation. Consult a qualified CPA or business attorney before making entity-election decisions.

(Firsthand insight: in over 15 years advising business owners, I’ve found that modeling cash flow after payroll and state fees — not just headline federal rates — is the single most important step in choosing between S and C status.)