The core difference between an S corp vs C corp comes down to one line in the tax code: a C corporation pays its own federal income tax and shareholders pay a second tax when profits come out as dividends, while an S corporation pays no entity-level federal tax and passes all income directly to shareholders, who report it once on their personal returns. That single split drives almost everything else that matters when you’re choosing between the two, including how you pay yourself, who can buy in, and what happens when you want to raise money or sell.
How Each Entity Is Taxed
A C corporation files Form 1120 and pays a flat 21% federal corporate income tax on its profits.1Internal Revenue Service. Forming a Corporation When those after-tax profits are distributed as dividends, shareholders pay again at their individual rate. Qualified dividends are taxed at 0%, 15%, or 20% depending on the shareholder’s income. This is the double taxation C corporations are known for.
An S corporation files Form 1120-S, but that return is informational.2Internal Revenue Service. About Form 1120-S, U.S. Income Tax Return for an S Corporation The corporation owes no federal income tax on operating earnings. Income and losses flow through to shareholders in proportion to their ownership and appear on each shareholder’s Schedule K-1.3Internal Revenue Service. Shareholder’s Instructions for Schedule K-1 (Form 1120-S) (2025) Each shareholder reports that income on Form 1040 at their individual marginal rate, which currently tops out at 37%.
The headline rates make C corporations look cheaper, but the full picture tells a different story. Say the business earns $100. A C corporation keeps $79 after the 21% corporate tax, and a dividend of that $79 taxed at 20% costs another $15.80, leaving the shareholder with $63.20. An S corporation shareholder paying the top 37% rate on the same $100 keeps $63. Roughly the same. Most S corporation owners, however, don’t pay the top rate, and most also qualify for a deduction that pushes the math further in their favor.
The QBI Deduction for S Corp Owners
S corporation owners can claim the Qualified Business Income deduction under Section 199A, which lets eligible pass-through owners deduct up to 20% of their qualified business income before calculating personal tax.4Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income The One Big Beautiful Bill Act made this deduction permanent starting in 2026. C corporations cannot claim it.
The deduction has income limits. For 2026, single filers above $201,750 of taxable income and joint filers above $403,500 enter a phase-in range. Once taxable income exceeds $276,750 (single) or $553,500 (joint), the deduction is capped at the greater of 50% of the business’s W-2 wages or 25% of W-2 wages plus 2.5% of the cost of depreciable property. Owners of specified service businesses like law, medicine, accounting, and consulting lose the deduction entirely above the upper threshold.
For S corporation owners whose income falls below those thresholds, the deduction effectively knocks the federal tax rate on pass-through income down by as much as 20%. An owner in the 24% bracket who qualifies for the full deduction pays an effective federal rate of roughly 19.2% on that income, well below the C corporation’s combined rate.
When a C Corp Wins on Taxes
C corporations have two tax advantages that S corporations cannot match.
The first is Section 1202, the qualified small business stock exclusion. Shareholders who sell qualifying C corporation stock may exclude a substantial portion of the capital gain from federal tax.5Office of the Law Revision Counsel. 26 U.S. Code 1202 – Partial Exclusion for Gain From Certain Small Business Stock S corporation shares never qualify. For stock acquired after July 4, 2025, holding for three years gets a 50% exclusion, four years gets 75%, and five years gets the full 100%. The maximum excludable gain per company is the greater of $15 million or ten times the shareholder’s adjusted basis, with the $15 million cap indexed for inflation starting in 2027. To qualify, the corporation must be a domestic C corporation with aggregate gross assets of $75 million or less when the stock is issued, and at least 80% of its assets must be used in an active qualified trade or business. Health, law, accounting, consulting, financial services, hospitality, and several other industries are excluded. For founders and early employees of qualifying startups, this exclusion can shelter millions of dollars in gain.
The second is the ability to retain earnings. A C corporation can hold after-tax profits inside the business indefinitely. Shareholders owe no additional tax until the money actually comes out as dividends, which gives the corporation flexibility to reinvest, build reserves, or fund acquisitions. The guardrail is the Accumulated Earnings Tax: if the IRS determines the corporation is stockpiling earnings primarily to help shareholders avoid dividend taxes, it can impose a 20% tax on the excess accumulation. The IRS generally treats the first $250,000 of accumulated earnings as presumptively reasonable, or $150,000 for personal service corporations in fields like accounting, law, and consulting.6Internal Revenue Service. Publication 542 (01/2024), Corporations Beyond those thresholds, the corporation needs concrete plans for the funds.
S corporation earnings work the opposite way. All income is taxed to shareholders in the year it’s earned, whether the cash is distributed or not. That can create phantom income: an owner may owe tax on $150,000 of pass-through income even though the corporation kept the cash to fund operations. The upside is that undistributed income increases the shareholder’s basis in the stock, reducing the taxable gain on a later sale.
Paying Yourself: Salary vs. Distributions
Both structures require owner-employees to receive a salary, but the payroll tax consequences differ sharply, and this is where the S corporation earns its popularity among small business owners.
In a C corporation, the owner’s salary carries the standard FICA taxes: 6.2% Social Security and 1.45% Medicare from the employee, matched by the corporation. Social Security applies on wages up to $184,500 in 2026.7Social Security Administration. What Is the Current Maximum Amount of Taxable Earnings for Social Security The corporation deducts the salary and its share of the payroll taxes.
An S corporation also pays FICA on the owner’s salary. But any profit distributed beyond the salary is classified as a distribution, not wages, and distributions are not subject to FICA taxes.8Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues An S corporation owner earning $200,000 who takes a $100,000 salary and $100,000 in distributions saves roughly $15,300 in combined FICA taxes on the distribution portion compared to taking the full amount as wages. This is the single most common reason small business owners elect S status.
The IRS watches this closely. S corporation owner-employees must receive “reasonable compensation” for the work they actually perform before taking distributions.8Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues Setting the salary too low is one of the most heavily audited issues in small business tax. If the IRS reclassifies distributions as wages, the corporation owes back payroll taxes, penalties, and interest. What counts as reasonable depends on the owner’s role, comparable salaries in the industry, and the company’s revenue.
There’s a related wrinkle for active owners above the Net Investment Income Tax thresholds ($200,000 single, $250,000 joint). C corporation dividends are always investment income and get hit with the 3.8% NIIT. S corporation pass-through income to an owner who materially participates escapes the NIIT entirely.9Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Passive S corporation shareholders still owe it.
Fringe Benefits and Retirement
C corporations get cleaner treatment for fringe benefits. Health insurance premiums, group life insurance, and similar benefits paid on behalf of an owner-employee are deductible by the corporation and excluded from the owner’s taxable income, same as for any other employee.
S corporation owners holding more than 2% of the stock get worse treatment. Health insurance premiums must be included in the owner’s W-2 wages. The owner can then claim the self-employed health insurance deduction on their personal return, which partly offsets the inclusion but doesn’t match the C corporation’s outright exclusion. Group life insurance and other welfare benefits are similarly taxable to greater-than-2% S corporation owners.8Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
Retirement contributions carry a tradeoff that catches many S corporation owners by surprise. Both entity types can sponsor 401(k) plans with the same employee deferral limit of $24,500 for 2026.10Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026 Employer contributions in both cases are calculated against W-2 wages. For S corporation owners, distributions don’t count as compensation for retirement plan purposes.11Internal Revenue Service. Retirement Plan FAQs Regarding Contributions – S Corporation An owner who takes a lower salary to save on FICA simultaneously reduces the base for employer retirement contributions. Finding the right split is one of the trickier optimization problems in small business tax planning.
Who Can Own Shares and Raise Money
C corporations face virtually no federal restrictions on ownership. Any person, corporation, partnership, LLC, trust, or foreign entity can be a shareholder. There’s no cap on the number of shareholders. The corporation can issue multiple classes of stock with different voting rights, dividend preferences, and liquidation priorities.
S corporations operate under tight constraints. Total shareholders are capped at 100, and shareholders must generally be U.S. citizens, U.S. residents, or certain qualifying trusts and estates.12Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined Other corporations, partnerships, LLCs, and nonresident aliens cannot own S corporation stock. Family members can elect to be treated as a single shareholder for the 100-count, which helps multigenerational businesses, but the cap still limits how broadly ownership can be spread.
The S corporation is also limited to a single class of stock, meaning all shares must carry identical rights to distributions and liquidation proceeds.13Internal Revenue Service. S Corporations Shares can differ in voting rights without violating this rule, but any variation in economic rights creates a second class of stock and kills the S election.
These restrictions matter the moment a company tries to raise institutional capital. Venture capital and private equity firms almost universally demand preferred stock when they invest, which gives them a liquidation preference, anti-dilution protection, and other rights that sit above common shareholders. An S corporation cannot issue a second class of stock, so it cannot accommodate the standard term sheet. Most VC and PE funds are also organized as partnerships or LLCs, neither of which can hold S corporation stock, and foreign investors are barred. The S corporation is structurally incompatible with how most growth-stage companies raise money. A C corporation has none of these limitations and can ultimately list shares on a public exchange through an IPO.
When Losses Pass Through
When an S corporation generates a loss, shareholders can deduct their share on personal returns, but only after clearing four successive hurdles. This trips up a lot of owners in the early years of a business.
- Stock and debt basis. The loss is deductible only up to the shareholder’s combined basis in their stock and any loans they’ve personally made to the corporation. Basis in stock comes from the original investment plus accumulated pass-through income, minus distributions and prior losses. A bank loan to the corporation does not give the shareholder debt basis, even if the shareholder personally guarantees the loan. Only direct loans from the shareholder count.
- At-risk limitation. Losses that pass the basis test must still be within the amount the shareholder has “at risk,” which generally mirrors basis but excludes certain nonrecourse financing.
- Passive activity limitation. If the shareholder doesn’t materially participate, losses are passive and can only offset other passive income.
- Excess business loss limitation. Even after clearing the first three, individual taxpayers face an annual cap on net business losses deductible against non-business income.
Losses that fail any of these tests aren’t gone forever. Losses blocked by the basis limitation carry forward indefinitely and can be used in a future year when basis increases through additional contributions or pass-through income. But if a shareholder sells or disposes of all their stock, any remaining suspended losses are permanently lost.14Internal Revenue Service. S Corporation Stock and Debt Basis This is a trap that catches shareholders who exit without first restoring enough basis to absorb suspended losses.
C corporation shareholders don’t face these limitations because losses stay inside the corporation. The corporation carries its own net operating losses forward to offset future corporate income. The tradeoff is that C corporation shareholders can never use the corporation’s losses to offset personal income from other sources.
Switching Between the Two
C to S
A C corporation elects S status by filing Form 2553 with the consent of all shareholders. To take effect for the current tax year, the form must be filed within two months and 15 days of the start of that year, or any time during the preceding year.15Internal Revenue Service. Instructions for Form 2553 (Rev. December 2020) For a calendar-year corporation, the deadline is March 15. Missing it doesn’t necessarily mean waiting a year; the IRS grants late election relief under Revenue Procedure 2013-30 if the corporation had reasonable cause and reported income consistently with the intended election.16Internal Revenue Service. Late Election Relief
Conversion triggers a potential Built-In Gains tax. Any asset the C corporation held at conversion that is sold within five years of the S election date may be taxed at the 21% corporate rate on the gain that existed on the conversion date.17Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains A professional appraisal at the time of conversion is essential for documenting the exposure.
A converted S corporation that still holds accumulated earnings and profits from its C years faces another hazard. If more than 25% of gross receipts are passive investment income in any year while those old C earnings remain, the corporation owes a 21% tax on the excess net passive income.18Office of the Law Revision Counsel. 26 USC 1375 – Tax Imposed When Passive Investment Income of Corporation Having Accumulated Earnings and Profits Exceeds 25 Percent of Gross Receipts Passive income here includes rents, royalties, dividends, interest, and annuities. If the 25% threshold is breached for three consecutive years, the S election terminates automatically.19Office of the Law Revision Counsel. 26 USC 1362 – Election; Revocation; Termination
S to C
Revoking an S election requires the consent of shareholders holding more than half the stock. The corporation files a revocation statement specifying an effective date. Filed by the 15th day of the third month of the tax year, the revocation can be effective as of the first day of that year; otherwise it takes effect the following year. This direction does not trigger an immediate corporate-level tax on asset appreciation. The company simply begins paying the 21% corporate tax, and shareholders face double taxation on future distributions.
Filing Deadlines and Penalties
The two returns are due at different times. Form 1120-S for an S corporation is due by the 15th day of the third month after year-end, March 15 for calendar-year companies. Form 1120 for a C corporation is due by the 15th day of the fourth month, April 15 for calendar-year filers.20Internal Revenue Service. Publication 509, Tax Calendars Both can request automatic extensions, which extend the time to file but not the time to pay.
The earlier S corporation deadline matters because shareholders need their K-1s to complete their personal returns. A late 1120-S delays every shareholder’s personal filing.
Late-filing penalties are also steeper for S corporations in practice. The penalty for a late Form 1120-S is $255 per shareholder per month for up to 12 months.21Internal Revenue Service. Failure to File Penalty A five-owner S corporation filing four months late owes $5,100. A ten-owner S corporation filing the same four months late owes $10,200. The per-shareholder structure means the penalty scales fast with ownership.
State filing requirements add another layer. Most states follow the federal S election, but several impose their own entity-level tax or franchise tax on S corporations. These range from nominal minimum fees to percentage-based taxes on net income, and the state tax picture should be part of any S-versus-C comparison for a specific business.