The choice between a C corp vs S corp comes down to how profits get taxed and who is allowed to own the company. A C corporation pays a flat 21% federal tax on its profits and shareholders pay again when they receive dividends. An S corporation pays no federal income tax at the entity level; profits flow through to shareholders and are taxed once on their personal returns. S status saves money for most small, closely held businesses, but it comes with ownership restrictions that rule it out for anyone planning to raise outside capital.
The Core Tax Difference
Every corporation starts as a C corporation under Subchapter C of the Internal Revenue Code. It files Form 1120 and pays 21% on its net profits regardless of size.1Internal Revenue Service. Instructions for Form 1120 (2025) The second layer of tax hits when profits reach the owners. Dividends paid to shareholders get taxed again on their personal returns. Qualified dividends run at long-term capital gains rates of 0%, 15%, or 20% depending on the shareholder’s income.2Internal Revenue Service. Topic No. 404, Dividends and Other Corporate Distributions For 2026, the 20% rate begins at taxable income above $545,500 for single filers and $613,700 for joint filers.3Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates Even at the lowest dividend rate, the same dollar of profit has been taxed twice.
An S corporation files Form 1120-S as an informational return and pays nothing at the entity level. Each shareholder receives a Schedule K-1 showing their share of profits, losses, deductions, and credits, and reports those amounts on their personal Form 1040. One dollar of profit, one round of tax.
There is a catch S corp owners often miss on the way in: you owe tax on your share of profits whether or not the company distributes cash. If the business earns $200,000 and reinvests every dollar, you still owe tax on your slice. Most S corporations distribute at least enough cash for shareholders to pay their tax bills, which limits how aggressively the business can reinvest.
C corporations that hoard profits face their own penalty. A 20% accumulated earnings tax applies to earnings retained beyond what the business reasonably needs, with a $250,000 cushion for most companies and $150,000 for professional service firms in fields like law, health, accounting, engineering, and consulting.4Office of the Law Revision Counsel. 26 USC 531 – Imposition of Accumulated Earnings Tax5Office of the Law Revision Counsel. 26 USC 535 – Accumulated Taxable Income The company can defeat the tax by documenting a legitimate business purpose for retaining the funds, but the burden of proof sits on the corporation.
Payroll Taxes and the Reasonable Salary Rule
The payroll tax split is where most small owners find real money in S corp status. An owner who works in the business must take a reasonable salary, and that salary carries the standard FICA taxes: 6.2% Social Security on wages up to $184,500 in 2026 and 1.45% Medicare, with matching amounts paid by the corporation.6Social Security Administration. Contribution and Benefit Base Profit distributed above the salary is not subject to FICA or self-employment tax.7Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers
A sole proprietor or single-member LLC owner pays 15.3% self-employment tax on all net business income. An S corp owner earning $300,000 who takes a $120,000 salary skips that 15.3% on the remaining $180,000, worth roughly $27,500 a year. The savings grow with profits.
Set the salary too low and the IRS can reclassify distributions as wages, adding back taxes, penalties, and interest. Courts have consistently backed the agency on this.7Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers There are no bright lines, but the IRS weighs factors including your training and experience, the actual duties and time you put into the business, what comparable companies pay for similar roles, and the corporation’s own dividend history and pay for non-shareholder employees.8Internal Revenue Service. Fact Sheet – S Corporation Compensation Deduction Research salary data for your role, pick a number inside that range, and keep the documentation in your corporate records before anyone asks for it.
The Qualified Business Income Deduction
S corp shareholders get a deduction their C corp counterparts do not. The Section 199A qualified business income deduction lets eligible taxpayers deduct up to 20% of their qualified business income from a pass-through entity before calculating income tax.9Internal Revenue Service. Qualified Business Income Deduction Income earned through a C corporation does not qualify.
An S corp shareholder with $200,000 of qualified business income could deduct up to $40,000, worth roughly $12,800 in federal tax at a 32% marginal rate. The deduction is limited by taxable income, the type of business, and the W-2 wages the business pays. Service-based businesses in law, consulting, and health care face additional restrictions once the owner’s taxable income clears certain thresholds. The provision was originally enacted under the Tax Cuts and Jobs Act and set to expire after 2025; the One Big Beautiful Bill Act signed in mid-2025 extended the pass-through provisions.
Who Can Own an S Corporation
S status comes with ownership rules under Section 1361 that every shareholder must satisfy at all times. Miss any one of them and the election terminates automatically.
- No more than 100 shareholders, with members of the same family counted as one.
- Shareholders must be U.S. citizens or resident aliens. Partnerships, other corporations, and most foreign investors cannot hold S corp shares.
- One class of stock. Voting and non-voting shares are allowed, but every share must carry identical rights to distributions and liquidation proceeds.
p>10Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined
C corporations face none of this. Unlimited shareholders, any type of owner including trusts, other corporations, foreign investors, and venture capital funds, and multiple classes of stock with different dividend rights, liquidation preferences, and voting structures. That flexibility is why nearly every company that goes public or takes institutional money is a C corporation.
Passive Income Termination Risk
A company that previously operated as a C corp and still holds accumulated earnings and profits from those years has an extra tripwire. If more than 25% of gross receipts come from passive sources like interest, dividends, rents, or royalties for three consecutive tax years, the S election terminates automatically.11Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination Distributing the old C corp earnings and profits eliminates the risk.
Where C Corporations Win
Two investment tax incentives apply only to C corp stock.
Qualified Small Business Stock (Section 1202)
Investors who hold stock in a qualifying C corporation for at least five years can exclude 100% of their capital gain on sale, up to the greater of $15 million or ten times their investment basis. The corporation must be a domestic C corp whose gross assets have never exceeded $75 million, and the stock must have been acquired at original issuance. The One Big Beautiful Bill Act raised those limits from the earlier $10 million and $50 million and introduced tiered exclusions for shorter holds: 50% after three years and 75% after four, with the full 100% still requiring five years. Any gain not excluded is taxed at 28%. S corp stock does not qualify.
Section 1244 Ordinary Loss Treatment
When a small corporation investment goes bad, Section 1244 lets shareholders treat the loss as an ordinary loss rather than a capital loss. Ordinary losses offset any type of income; capital losses are capped at $3,000 against ordinary income each year. The annual limit on Section 1244 treatment is $50,000 for individuals and $100,000 for joint filers.12Office of the Law Revision Counsel. 26 USC 1244 – Losses on Small Business Stock Both C and S corp stock can qualify, but the benefit matters most to C corp investors carrying the greater downside of double taxation.
How to Elect S Status
Switching from the default C status to S requires Form 2553, signed by every shareholder.13Internal Revenue Service. About Form 2553, Election by a Small Business Corporation File it no more than two months and 15 days after the start of the tax year you want it to cover, or any time in the preceding tax year. Miss the window and the election waits until the following year. Late election relief is available under Revenue Procedure 2013-30 if you can show reasonable cause, but that is a fallback, not a plan.14Internal Revenue Service. Instructions for Form 2553 – Election by a Small Business Corporation Once the IRS processes the election it sends a CP261 notice confirming the effective date; keep that notice in your permanent records.15Internal Revenue Service. Understanding Your CP261 Notice
If you are converting an existing C corporation that owns appreciated assets, the built-in gains tax applies for five years after conversion. Selling those assets inside that window triggers tax at the top corporate rate of 21% on the recognized built-in gain.16Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains Factor this into the timing if the corporation holds substantially appreciated real estate or other assets.
Losing S Status
S status ends three ways: voluntary revocation, automatic termination for failing eligibility, or the passive income trap. Voluntary revocation needs consent from shareholders holding more than half the shares.11Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination Filed in the first two months and 15 days of the tax year, it applies to that year; filed later, it applies to the next year unless the shareholders pick a future date. Involuntary termination happens the moment an eligibility requirement fails, such as a share sale to a foreign investor or an inadvertent second class of stock.
Either way the company reverts to C status, and the IRS generally will not allow a new S election for five tax years absent special permission.17Internal Revenue Service. Instructions for Form 2553 A careless mistake on shareholder eligibility can lock the company out of pass-through treatment for half a decade.
What Stays the Same
The tax election does not change state corporate law. Both entity types must hold annual shareholder and board meetings, keep minutes, maintain bylaws, separate corporate and personal accounts, and file whatever periodic report the state requires. Governance and liability protection work identically.
State tax treatment is another matter. A handful of states impose their own entity-level taxes on S corporations or do not fully recognize the federal S election, so check your state’s rules before assuming pass-through treatment applies at every level.