C Corp vs S Corp Tax Structure: Key Differences Explained

Key Takeaways

• C corps are subject to double taxation, paying corporate income tax on profits and shareholders paying taxes again on dividends.
• S corps are pass-through entities, meaning income, deductions, and credits flow to shareholders’ personal tax returns.
• Choosing between a C corp vs S corp depends on factors like company size, growth plans, shareholder structure, and preferred tax treatment.
• Reasonable salary rules require S corp owners working as employees to be paid fair market wages before profits are distributed.
• S corps have ownership restrictions (e.g., max 100 shareholders, only one class of stock, and no foreign shareholders), while C corps are more flexible for large or public companies.
• C corps are often preferred by investors and venture capital firms because they allow multiple stock classes and easier equity-based compensation.

Within the S corp tax structure, a corporation is treated as a pass-through entity for tax purposes. S corporations issue stock and function like traditional C corporations. Owners also benefit from the same liability protections as C corporation shareholders.

C Corporation Taxation

In the United States, corporations can choose to be taxed at the corporate or shareholder level. A corporation that opts to be taxed at the corporate level is a C corporation. A C corporation pays a corporate tax on net income and, when it distributes dividends, its shareholders are taxed at the shareholder level, as well.

How C Corporation Taxation Works in Practice

C corporations are considered separate legal entities, which means they pay federal corporate income tax on their net income before profits are distributed to shareholders. The current federal corporate tax rate is a flat 21%. However, when profits are distributed as dividends, shareholders must report this income on their personal tax returns — leading to the well-known “double taxation” issue.

Despite this, C corp status can offer advantages in certain cases:

• Retained Earnings: C corps can retain earnings within the company for reinvestment without immediately triggering shareholder taxes.
• Tax-Deductible Benefits: They can provide a wider range of tax-deductible benefits (such as health insurance and retirement plans) to owners and employees.
• Access to Investors: Because C corps can issue multiple classes of stock, they are often preferred by venture capitalists and can more easily go public.

S Corporation Taxation

A corporation can choose to instead only be taxed at the shareholder level. The corporation still files its own return, although it's mostly informational in nature. Taxable income plus deductions and credits are then divided among shareholders. Each shareholder is required to include this amount on his or her personal tax return. The company typically pays no income taxes at the corporate level. This is called S corporation status, and the letter S is in reference to Internal Revenue Code Subchapter S.

S corporations use IRS Form 1120S to file their annual returns. Schedules K and K-1 show how income and deductions are allocated between shareholders. The S corporation doesn't pay federal income tax and instead passes it along to the shareholders, who are taxed on their income share.

Shareholders are not required to pay self-employment tax on their share of the profits, but before profits are distributed, owners who are also employees must receive a "reasonable salary." It's important to note that the share of business income is taxed regardless of whether it was distributed to shareholders.

S corporations must pay some taxes at the corporate level:

• Excessive net passive income
• Built-in gains tax
• LIFO recapture tax

Passive income includes things like interest income, dividends, rents, royalties, and annuities. An excess net passive income tax applies if passive income is more than 25 percent of the gross receipts.

Pass-Through Benefits and Tax Implications for S Corps

S corporations are treated as pass-through entities, meaning they do not pay federal income tax at the corporate level. Instead, profits and losses are reported on each shareholder’s personal tax return in proportion to their ownership share. This avoids double taxation and often results in lower overall tax liability, especially for small and mid-sized businesses.

However, S corps are not entirely free of corporate-level taxes. Certain taxes — such as built-in gains tax, passive income tax, and LIFO recapture tax — may still apply. Additionally, shareholders must report their share of business income even if profits are not distributed, potentially increasing their personal tax burden.

Reasonable Salaries

One of the major benefits of S corporations is that shareholders aren't required to pay self-employment taxes on their share of the profits. There is a catch, however, in that before profits are calculated, any owner who works as an employee must be paid a "reasonable salary."

This salary amount will be subject to Medicare and Social Security taxes, half of which the corporation pays and half the employee pays. Savings from not having to pay self-employment taxes don't take effect until the company is earning enough money to have profits after paying out reasonable salaries.

Reasonable salaries are frequent topics in court cases where the IRS believes business owners are paying small salaries to avoid self-employment taxes. The IRS tax code doesn't define or provide specific details on what constitutes a reasonable salary.

If a case goes to court, the IRS often looks at a variety of issues prior to ruling on the matter:

• Responsibilities and duties of the shareholder (employee)
• Experience and training
• How much time is devoted to the business
• How much in dividends were paid to shareholders
• Wages of employees who aren't shareholders
• What similar businesses pay for comparable services

IRS Oversight and Compliance Tips

The “reasonable salary” requirement is a key area of IRS scrutiny for S corps. Owners working as employees must pay themselves a salary comparable to what someone in a similar position would earn in the open market. Paying an unreasonably low salary to avoid payroll taxes can trigger audits, penalties, and back taxes.

To stay compliant:

• Document how you determined the salary (e.g., industry benchmarks, role responsibilities, company size).
• Review salaries annually to ensure they remain reasonable as the business grows.
• Consult a tax professional to structure compensation and distributions strategically.

Advantages of S Corporations

• You can transfer ownership interests without negative tax consequences.
• S corporations are not forced to use the accrual method of accounting like C corporations are.
• S corporations often have better credibility with clients, customers, vendors, employees, and partners because of the formal commitment required to incorporate.

Comparing C Corp vs S Corp for Growth and Investment

The choice between a C corp vs S corp often depends on long-term business goals. While S corporations are ideal for small to mid-sized companies seeking pass-through taxation and simpler tax reporting, C corporations may offer strategic advantages for growth-oriented businesses.

When a C Corp Might Be Better:

• You plan to seek venture capital or go public.
• You want to offer multiple stock classes or complex equity incentives.
• You expect to retain profits in the business rather than distribute them immediately.

When an S Corp Might Be Better:

• You prefer a single layer of taxation and want profits to pass through to personal returns.
• Your ownership structure is relatively simple, with fewer than 100 shareholders.
• You want to minimize self-employment taxes on distributions.

Potential Disadvantages of S Corporations

• Ongoing fees are higher than what a sole proprietor or partnership would incur.
• S corporations must adopt a calendar year for tax purposes unless the company can establish a business purpose for using a fiscal year.
• Because an S corporation can only have one class of stock, there are no investor classes where shareholders are entitled to different distribution rights or dividends.
• There's a cap of 100 shareholders.
• Foreigners and certain types of trusts and other entities cannot be shareholders.
• Because S corporations can only issue one type of stock, they cannot allocate income to specific shareholders easily.
• For shareholders with more than 2 percent ownership, many fringe benefits (medical insurance, life insurance, etc.) provided by the S corporation are taxable.

Common Pitfalls When Choosing an S Corp

While the tax savings of an S corp are attractive, they come with compliance and growth limitations that can hinder some businesses. Strict shareholder eligibility requirements — including a 100-shareholder cap and U.S. residency rules — can limit opportunities for outside investment. The single-class-of-stock rule can also make it harder to structure deals with investors or key employees.

Moreover, because shareholders must report income whether or not it’s distributed, they may face unexpected tax bills even without receiving cash. Lastly, S corps are more closely monitored by the IRS, particularly around reasonable compensation and shareholder distributions, increasing the importance of meticulous recordkeeping and compliance.

Frequently Asked Questions

1. What is the main tax difference between a C corp and an S corp?
   C corps pay corporate tax on profits and shareholders pay tax again on dividends. S corps pass income directly to shareholders, who report it on their personal tax returns.
2. Can an S corp become a C corp (or vice versa)?
   Yes. A business can revoke its S election and revert to C corp status, or a C corp can elect S status if it meets IRS requirements.
3. Why would a startup choose a C corp over an S corp?
   C corps can issue multiple classes of stock, attract venture capital, and go public — all critical for fast-growing startups.
4. Are there state taxes on S corps?
   Some states impose franchise or entity-level taxes on S corps, even though they are pass-through entities federally. Check your state’s rules.
5. How do reasonable salaries affect S corp taxation?
   S corp owner-employees must pay themselves a fair market salary subject to payroll taxes before taking profit distributions, which are not subject to self-employment tax.

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