Key Takeaways

  • A Subchapter C corporation is taxed separately from its owners, unlike a Subchapter S corporation where income passes through to shareholders’ personal tax returns.
  • C corporations face double taxation: profits are taxed at the corporate level and again as dividends at the shareholder level.
  • S corporations avoid double taxation but have stricter eligibility rules, including a 100-shareholder cap and restrictions on ownership.
  • C corporations are generally preferred for attracting public and private investors due to their flexible stock structures and lack of shareholder limits.
  • Choosing between S and C corporation status depends on factors such as ownership goals, tax planning, and long-term growth strategy.

Subchapter S corporation taxation refers to the tax treatment that corporations eligible for the election of a subchapter S can receive.

The S corporation is the fastest-growing of the different pass-through businesses. An S corporation is a domestic corporation that is viewed as a company that is pass-through. This means that the income of the corporation is allocated to the managers. The owners then must pay taxes for the income when they file their personal tax return. Just like the owners of other businesses that are pass-through, the managers of S-corporations face tax rates that are marginal as do individual wage earners. 

How much managers of an S-corp pay when it comes to taxes depends largely on the role they play in a business. A passive shareholder doesn't participate in the daily operations of an S-corporation. On the other hand, an active shareholder does. 

Every manager of an S-corp is responsible for paying federal income taxes on the individual level. As of 2015, the top marginal rate was 39.6 percent. Managers have the responsibility to pay local and state income taxes, which range from 0 to 13.3 percent as of 2015. These managers are also impacted by a Pease limitation when it comes to itemized deductions, tacking 1.18 percent more on the marginal tax rate as of 2015.

The distinction in how much tax every manager type is subjected to depends on how the Net Investment Income Tax of the ACA and the payroll tax impact them. The payroll tax refers to the tax that is responsible for funding Medicare and Social Security. 

Shareholders who are active typically receive two forms of income from the S-corp: a profit distribution and a wage income.

The payroll tax is applicable to the wage income, as of 2015. The payroll tax is as follows:

  • 15.3 percent for the first $117,000.
  • 2.9 percent for an additional $83,000.
  • 3.8 percent for any income that exceeds $200,000. 

The payroll tax is not applicable to the profit distribution.

If an owner gets $200,000 in total income and 50 percent of the $200,000 is wage income, then he will have to pay 15.3 percent of the $100,000 in wage income, which is $15,300. The rest of the income will not be subject to the tax.

Considering that there is a huge incentive to allocate more profit and pay very little wage, the IRS has established a few businesses guidelines to follow. Top tax rates (marginal) for shareholders who are active depend on if the last dollar is wage or profit. On the other hand, passive shareholders don't have to pay a payroll tax for income because they don't earn a wage through the business. Rather, passive shareholders are subject to the Net Investment Income Tax of the ACA, which is 3.8 percent as of 2015. This tax only comes into play when income is over $200,000 or over $250,000 for those filing jointly. Due to this, passive shareholders tend to pay higher top tax rates (marginal) than shareholders who are active.

Corporation Basics

For most small business owners, S corporations are more attractive than standard corporations, which are also referred to as C corporations. This is because S corporations have excellent tax benefits while still offering business owners the liability protection that is characteristic of a corporation.

If a corporation decides to pay its taxes at the corporate level, the corporation will file a corporate tax return, measure the taxable income, and use the corporate tax rates to calculate its tax. A corporation that receives this treatment is a C corporation. When C corporations allocate profits, in the form of dividends, to the shareholders, the dividends become taxable income for the shareholder.

Corporations also have the option of choosing to pay any taxes at the shareholder level. If a corporation chooses this option, it will still need to file its own corporate tax return and measure the taxable income.

The taxable income, however, is allocated among the shareholders. Tax credits and some deductions are also divided among the shareholders. Every shareholder will include their portion of the income, credits, and deductions as part of their personal tax return.

A income tax does not apply at the corporate level. Rather, personal income tax rates (pass-through) are used to tax all items of income. A corporation that receives this treatment is an S corporation.

Understanding Subchapter C Corporations

A Subchapter C corporation—often simply called a C corporation—is the default classification for corporations under the Internal Revenue Code. Unlike S corporations, C corporations are treated as separate taxpaying entities. They file their own corporate tax return (Form 1120) and pay taxes at the corporate rate on net earnings. When those earnings are distributed to shareholders as dividends, they are taxed again at the individual level—creating what is commonly referred to as double taxation.

Key characteristics of Subchapter C corporations include:

  • Unlimited shareholders – No restrictions on the number or type of owners, allowing for both domestic and foreign investors.
  • Multiple stock classes – Ability to issue various types of stock (e.g., common and preferred) with different voting and dividend rights.
  • Attraction of capital – Flexibility in ownership and stock types makes C corporations the preferred choice for raising funds from venture capitalists and going public.
  • Perpetual existence – The entity continues regardless of changes in ownership.
  • Corporate formalities – Must maintain a board of directors, hold annual meetings, and keep proper records.

Because of the potential for higher overall taxes due to double taxation, many small businesses opt for S corporation status if they meet the eligibility requirements. However, companies planning to reinvest profits for growth or seek institutional investment often remain C corporations to benefit from the expanded ownership flexibility.

Frequently Asked Questions

  1. What is the main difference between a Subchapter C corporation and an S corporation? A Subchapter C corporation pays corporate income tax and may face double taxation, while an S corporation passes income directly to shareholders to be taxed at their individual rates.
  2. Can a corporation switch from S status to C status? Yes. A corporation can revoke its S election and revert to C corporation status, but certain restrictions and timing rules apply.
  3. Why would a business choose to be a C corporation? Businesses often choose C corporation status to attract larger investments, issue multiple classes of stock, and have no shareholder limits.
  4. Are C corporations better for going public? Yes. C corporations are generally required for listing on public stock exchanges and are structured to handle a large, diverse shareholder base.
  5. Do C corporations always pay more taxes than S corporations? Not necessarily. While double taxation is a concern, strategic tax planning, reinvestment of earnings, and corporate deductions can sometimes make C corporation taxation more favorable.

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