Key Differences Between S Corp and C Corp

Key Takeaways

• The difference between S corp and C corp lies primarily in taxation, ownership rules, and stock structure.
• S corporations enjoy pass-through taxation but have strict shareholder limits and eligibility restrictions.
• C corporations face double taxation but offer flexibility in ownership, unlimited shareholders, and investor appeal.
• Each structure provides limited liability protection, shielding owners’ personal assets.
• The right choice depends on business goals, growth plans, and tax considerations.
• An attorney on UpCounsel can help you choose and maintain the best corporate structure for your business.

Definition of a Subchapter S Corporation

When learning about S corporation restrictions, it is important to know the definition of a subchapter S corporation. An S corporation is a business entity that has between one and 100 stockholders and benefits from pass-through tax status.  An S corporation is defined under the IRS Code Chapter 1, Subchapter S, which outlines the eligibility requirements for a corporation to allowed to be classified as an S corporation.

To qualify as an S corporation, a business must:

• Notify the IRS of their intent to be taxed as an S corporation within a specific amount of time.
• They must file their corporation's Article of Incorporation with the Secretary of State.
• They must file an IRS Form 2553 stating their intent to become an S corporation.

An S corporation can not only be valuable to a business for tax purposes but also can be beneficial if it comes time for the business to be discontinued or ownership to be changed.

Understanding the Difference Between S Corp and C Corp

While both S corporations and C corporations offer liability protection and formal corporate structures, they differ in significant ways that affect how a business operates and pays taxes. The difference between S corp and C corp begins with how each is recognized by the Internal Revenue Service (IRS). A C corporation is the default corporate entity, while an S corporation is a tax election made by filing Form 2553 with the IRS.

S corporations are pass-through entities, meaning profits and losses are reported on shareholders’ individual tax returns. C corporations, however, are taxed at the corporate level, and shareholders are also taxed on dividends—creating the “double taxation” issue that many small businesses try to avoid.

Key distinctions include:

• Formation: Both require filing Articles of Incorporation, but only S corps must elect special tax status.
• Taxation: S corps avoid double taxation, while C corps are taxed separately.
• Ownership limits: S corps can have up to 100 shareholders; C corps have no limit.
• Stock structure: S corps can issue only one class of stock, while C corps can issue multiple.
• Investor appeal: C corps are preferred by venture capitalists and institutional investors because of flexible ownership and stock options.

Taxation of a C Corporation

One of the most apparent differences between an S corporation and a C corporation is in the way that the corporations are taxed.  A C corporation is subject to double taxation, and its income is taxed at both the corporate and shareholder level. An S corporation, on the other hand, is a pass-through entity, so its income is only taxed at the shareholder level.

 A C corporation is required to file an 1120 corporate tax form and pays taxes based on the income they earned. A corporation has the right to keep its profits and earnings to be used as operating capital to the business or may choose to distribute their earnings to their shareholders in dividends. The shareholders of a C corporation will pay taxes on these dividends on their personal tax return. This creates a double taxation for C corporations as they will be required to pay taxes at both the corporate level as well as at the shareholder level.

Taxation of S-Corporations

One of the benefits of an S corporation is that it is not subject to corporate tax rates. In general, S corporations are exempt from any federal income tax except the tax on some passive income and capital gains. Instead of a corporate tax, an S corporation will use a pass-through taxation structure which will pass the taxation on its profits and losses to its shareholders.

Shareholders will be taxed based on the tax rates they qualify for on their 1040. By taxing income at only the shareholder level, S corporations avoid the double taxation that C corporations face. Similar to C corporations, S corporations are allowed to use profits as operating capital or distribute their profits to shareholders. Either way, the shareholder will be taxed on their portion of the business' tax liability even if they do not receive the dividends.

Comparing Taxation: S Corp vs C Corp

The difference between S corp and C corp taxation is often the deciding factor for business owners.

• C corporations pay federal corporate income tax on profits at the current flat rate of 21%. When dividends are distributed, shareholders also pay personal income tax—resulting in double taxation.
• S corporations, by contrast, do not pay corporate tax. Instead, income flows directly to shareholders, who report it on their personal tax returns. This avoids corporate-level taxation and can lower overall tax liability for smaller businesses.

However, S corporation owners must pay themselves a reasonable salary, subject to employment taxes. Remaining profits can then be distributed as dividends, which are not subject to self-employment taxes. This structure offers potential tax savings but requires compliance with IRS rules to avoid reclassification of income.

What Is the Eligibility Criteria for S-Corporations?

While an S corporation is a popular tax election for many types of businesses, there are criteria that need to be met before a corporation can be considered eligible for S corporation designation. Some of the criteria for becoming an S corporation include:

• The company must be a domestic entity. 
• All shareholders must be U.S. citizens. 
• The corporation must file a Form 2553 with the IRS.
• The company must be comprised of less than 100 shareholders.
• All shareholders must fall under the classification of an individual, estate, exempt organization, or trust.
• Shareholders cannot be nonresident aliens.
• The company can offer only one class of stock (but they can offer both voting and nonvoting shares).
• The company cannot be classified as an ineligible organization.
• The company must adopt one of the following tax years: calendar year ending December 31st, a natural business year, the ownership year, a tax year selected under section 444, or another tax year selected for a business purpose.
• All shareholders must consent to having the business classified as an S corporation.

Ownership and Stock Restrictions Compared

A core difference between S corp and C corp lies in their ownership and stock rules:

• S corporations are limited to 100 shareholders, all of whom must be U.S. citizens or residents. They may not include partnerships, corporations, or foreign investors. Additionally, S corps can issue only one class of stock, which ensures equal treatment of shareholders.
• C corporations, on the other hand, have no ownership restrictions. They can have unlimited shareholders, including foreign entities, and may issue multiple classes of stock. This makes C corps ideal for larger businesses and those planning to raise venture capital or go public.

These distinctions give C corporations a clear advantage in terms of growth potential and investment opportunities, while S corporations remain attractive for smaller, closely held companies seeking tax efficiency and simple ownership structures.

The Advantages of an S Corporation

An S corporation has many benefits that far outweigh any disadvantages. Some of the advantages of classifying your corporation as an S corporation include:

• Protection of the shareholder's personal assets.
• Pass-through taxation prevents the double taxation of other corporate structures.
• An easy transfer of ownership in the event of an owner's death or departure from the company.
• The ability to use the cash method of accounting when the business does not have inventory.

Advantages and Disadvantages of Each Corporate Type

When deciding between the two, understanding the advantages and disadvantages of S corps vs C corps is essential.

Advantages of S Corporations:

• Avoids double taxation through pass-through taxation.
• Offers liability protection for shareholders.
• Allows business income to be taxed at individual rates.
• Simplifies taxation for small or family-owned businesses.

Disadvantages of S Corporations:

• Restricted to 100 U.S. shareholders.
• Limited ability to attract investors due to one class of stock.
• Must adhere to IRS requirements for reasonable shareholder compensation.

Advantages of C Corporations:

• Unlimited growth potential with no shareholder limit.
• Ability to issue multiple stock classes (common and preferred).
• Greater appeal to investors, venture capitalists, and public markets.
• Retained earnings can be reinvested in the company.

Disadvantages of C Corporations:

• Subject to double taxation (corporate and individual).
• More complex compliance and reporting requirements.
• Potential for higher administrative costs.

Choosing Between an S Corp and a C Corp

When deciding on the right structure, consider the size, ownership goals, and long-term strategy of your business. If your company plans to seek outside investment or go public, a C corporation may be the better choice. If you prefer to minimize taxes and keep ownership limited to a small group, an S corporation may be ideal.It’s also important to consider state-level taxes and filing requirements, as some states do not recognize S corp status and may still tax the entity as a C corporation.

If you’re unsure which option best fits your goals, you can consult a business attorney on UpCounsel for tailored advice on formation, tax strategy, and compliance.

Frequently Asked Questions

1. What is the main difference between an S corp and a C corp?
   The main difference is taxation: S corps use pass-through taxation, while C corps are taxed at both the corporate and shareholder levels.
2. Can a business switch from a C corp to an S corp?
   Yes, a C corp can elect S corporation status by filing IRS Form 2553, provided it meets all eligibility requirements.
3. Do S corp owners pay self-employment taxes?
   Shareholders pay themselves a reasonable salary subject to payroll taxes, but distributions are not subject to self-employment taxes.
4. Can S corporations have foreign investors?
   No. Only U.S. citizens or resident individuals can be S corp shareholders, while C corps can have foreign ownership.
5. Which is better for raising capital—S corp or C corp?
   C corporations are better suited for raising capital since they can issue multiple stock classes and have no limits on shareholders.

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