C Corporation vs S Corporation: How to Apply and Qualify

Key Takeaways

• The main difference between a C corporation and an S corporation lies in how profits are taxed—C corporations face double taxation while S corporations enjoy pass-through taxation.
• To apply for S corp status, a business must first form a C corporation or LLC and then file IRS Form 2553.
• S corporations have strict ownership restrictions, including a 100-shareholder limit and only one class of stock.
• C corporations can have unlimited shareholders, multiple stock classes, and are generally preferred for large or venture-backed companies.
• Filing deadlines, shareholder consent, and accurate recordkeeping are critical to successful S corp election.
• Some states require an additional state-level S corp election, and S corps must adhere to ongoing IRS and state compliance obligations.
• Choosing between a C corporation and S corporation impacts taxation, fundraising, and long-term business strategy.

How to File for S Corporation Status

The S corp application is IRS Form 2553. It is titled “Election by a Small Business Corporation” and gives detailed information about your business to the IRS, including its eligibility. The steps are as follows:

• Make sure your business is eligible to elect S corporation status. All shareholders must approve the decision.
• Get all your shareholders to sign the form.
• Submit the form. The address depends upon your business' principal location.
• You will be notified by the IRS service center whether it has accepted your application.
• Your status as an S corporation will be valid until you choose to terminate it or the IRS revokes it.

If you are filing for S corporation status in New York, New Jersey, or Arkansas, you are required to file an application for election with the state after your status is approved by the IRS.

Common Mistakes to Avoid in an S Corp Application

When completing your S corp application, accuracy and timing are critical. Common mistakes that can lead to delays or IRS rejection include:

• Missing the filing deadline — not submitting Form 2553 within the 2-month-and-15-day window for the intended tax year.
• Incomplete shareholder signatures — all shareholders must consent to the election in writing on the form.
• Incorrect shareholder information — errors in names, Social Security numbers, or ownership percentages can cause issues.
• Ineligible shareholders — including foreign investors or entities that are not permitted to own S corp shares.
• Wrong tax year election — if choosing a tax year other than the calendar year, you must meet IRS qualifications and attach additional statements.

Double-check all information before submission and consider working with a tax professional to avoid costly errors.

What Are the Qualifications?

There are several requirements the IRS has for eligibility as an S corporation:

• The corporation must be domestic with no investors from foreign countries.
• The corporation must have 100 or fewer shareholders.
• The fiscal year of the corporation must end on December 31.
• The corporation must not be a business type that is ineligible, which includes banks and insurance companies.
• The corporation must be owned by individuals, some trusts, and estates.
• Shareholders must be United States citizens or legal residents.

Differences Between a C Corporation and an S Corporation

Before applying for S corporation status, it’s important to understand how it differs from a C corporation. Both are formed under state law by filing Articles of Incorporation and both provide limited liability protection to shareholders. However, their federal tax treatment and ownership rules differ significantly:

• Taxation:
  • A C corporation pays corporate income tax on profits and shareholders also pay taxes on dividends, resulting in double taxation.
  • An S corporation, by contrast, allows income, losses, deductions, and credits to “pass through” to shareholders’ individual tax returns, avoiding double taxation.
• Shareholders:
  • C corporations can have an unlimited number of shareholders, including foreign investors and other entities.
  • S corporations are limited to 100 shareholders, and all must be U.S. citizens or residents.
• Stock classes:
  • C corporations may issue multiple classes of stock, such as common and preferred shares.
  • S corporations can issue only one class of stock, though differences in voting rights are allowed.
• Growth potential:
  • C corporations are generally better suited for companies seeking venture capital or public investment, as most investors prefer the flexibility of multiple stock classes and dividend structures.
  • S corporations are better for small to mid-sized businesses that want pass-through taxation and simpler ownership structures.

These differences help determine whether electing S corporation status is beneficial based on your company’s size, growth goals, and funding needs.

Additional State-Level Requirements for S Corps

While the IRS governs the federal S corp election, some states impose their own requirements:

• Separate state election — States like New York, New Jersey, and Arkansas require an additional S corp election filing after IRS approval.
• Annual state reports — Many states require annual filings to maintain good standing, which may differ from federal requirements.
• State-level taxes — Certain states, such as California, impose annual franchise taxes or fees on S corps, regardless of federal pass-through taxation.

Failure to meet these state-specific rules can result in losing your S corp status at the state level, even if your federal election remains valid.

When Should You File the Form?

IRS rules require that your S corporation election form be submitted within two months and 15 days after the tax year begins. If you are starting a new business, this must be done during its first year. If it is not filed on time, you will not have status as an S corporation for that tax year. However, if you can explain a legitimate reason for not filing on time, you can request that the IRS accepts your late election.

Filing Late: Reasonable Cause and Relief Options

If you miss the S corp application deadline, the IRS may still grant late election relief if you can show “reasonable cause.” Common reasons that may be accepted include:

• Miscommunication between shareholders and tax preparers.
• Incorrect advice from a tax professional regarding filing deadlines.
• Administrative errors, such as misplacing the form or sending it to the wrong IRS address.

To request relief, attach a detailed explanation to your Form 2553 or file IRS Form 1120-S with the appropriate statements. The IRS will review your request and determine if late election is justified.

Why Should You Choose Status as an S Corporation?

There are several reasons why an S corporation status is attractive for many businesses. For one thing, it offers liability protection just like a C corporation. It is considered a separate entity, with owners being protected from debts and lawsuits involving the corporation. There are, however, situations in which this protection is not valid, such as when an owner personally guarantees a loan or commits fraud.

Taxes are another reason to elect S corporation status. Owners can reduce the amount of self-employment taxes they pay. Owners of S corporations may be considered employees, so part of their profit distribution may be considered wages and, therefore, not subject to self-employment tax. Instead, the S corporation withholds the tax as a regular income deduction.

C corporations are subject to double taxation, and S corporation status can eliminate that. Corporations pay corporate income tax, and the owners are also taxed on their dividends or profit distributions. This is considered double taxation. Since an S corporation does not pay tax on its own behalf, the profits are only taxed once, as it passes through to the shareholders' personal tax returns.

Losses from S corporations can reduce the amount of taxes owners must pay. Since losses are passed through to the owners just like profits, it reduces the total taxable amount for the shareholders.

Owners of S corporations pay taxes at personal income tax rates, which are lower than corporate tax rates. Therefore, it lowers the amount of taxes paid by the owners.

Comparing C Corporation and S Corporation Tax Benefits

When evaluating C corporation vs S corporation tax advantages, consider both short-term and long-term impacts on profitability and shareholder returns:

• S Corporation Tax Benefits:
  • Profits are taxed only once at the shareholder level.
  • Owners may classify part of income as salary and part as dividends, which can reduce self-employment tax liability if structured properly.
  • Losses can offset other personal income, reducing total tax owed.
• C Corporation Tax Benefits:
  • The corporate tax rate (currently 21%) can be advantageous for reinvesting profits.
  • C corporations can retain earnings without immediately distributing them to shareholders.
  • They can issue stock options and attract institutional investors more easily.

However, a C corporation faces double taxation if it distributes profits as dividends. An S corporation avoids this but must follow strict IRS eligibility and compliance rules. Businesses often start as C corporations and later elect S corp status once they qualify.

Potential Tax Savings With an S Corp Election

One of the main reasons businesses file an S corp application is to reduce self-employment tax liability. In an S corp:

• Owners can split income into reasonable salaries (subject to payroll taxes) and distributions (not subject to self-employment tax).
• This structure can significantly reduce tax liability compared to sole proprietorships or partnerships, as long as salaries meet IRS standards for reasonableness.
• The pass-through taxation structure helps avoid the double taxation faced by C corporations, where both corporate profits and shareholder dividends are taxed.

However, improper salary levels or poor recordkeeping can trigger IRS scrutiny, so maintaining compliance is essential.

Obtaining a Federal Tax ID

One important step for S corporations is getting an Employer Identification Number, also referred to as a Federal Tax ID number. This is a nine-digit number issued by the IRS. It is necessary even though the company does not pay its own taxes.

Steps to Take After Your S Corp Application Is Approved

Once the IRS approves your S corp election, you should:

1. Update business records — Notify your accountant, update payroll systems, and adjust financial statements to reflect the new tax classification.
2. Set up payroll — If owners are taking salaries, ensure payroll taxes are withheld and remitted properly.
3. Maintain corporate formalities — Keep meeting minutes, update bylaws, and ensure compliance with both federal and state requirements.
4. File annual returns — Submit IRS Form 1120-S and provide Schedule K-1 to each shareholder.

Following these steps helps preserve your S corp status and prevents administrative issues.

Maintaining Compliance for Your S Corporation

Once your S corporation election is approved, compliance becomes a continuous process:

1. File annual reports with your state and submit IRS Form 1120-S each tax year.
2. Provide Schedule K-1 to shareholders, reporting their share of profits or losses.
3. Hold regular shareholder meetings and document corporate minutes.
4. Maintain payroll compliance by ensuring reasonable compensation for shareholder-employees.
5. Reconfirm shareholder eligibility annually to ensure all owners remain qualified under IRS rules.
6. Monitor state tax obligations, as some states like California and New York levy franchise or excise taxes even on S corps.

Failure to meet these obligations could result in revocation of S corp status, effectively reverting the business to a C corporation.

Frequently Asked Questions

1. Can a C corporation become an S corporation?
   Yes. A C corporation can elect S corp status by filing Form 2553 with the IRS, provided it meets eligibility requirements like shareholder and stock class restrictions.
2. Can an LLC apply for S corp status?
   Yes. An LLC can elect to be taxed as an S corporation by first filing Form 8832 to be taxed as a corporation and then Form 2553 for S corp election.
3. Which is better for small businesses — C corporation or S corporation?
   S corporations are often preferred by small businesses for their pass-through taxation and simpler structure, while C corporations benefit companies seeking outside investors or plans to go public.
4. What happens if an S corp violates eligibility rules?
   The IRS may terminate S corp status, converting it back into a C corporation. This can trigger significant tax consequences.
5. Do both C and S corporations provide liability protection?
   Yes. Both structures shield owners from personal liability for business debts and legal obligations, though maintaining proper corporate formalities is essential to preserve this protection.

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