The core difference between an S corp and a C corp is how the IRS taxes profits. A C corporation pays a 21% federal corporate income tax on its earnings, and shareholders pay again when those earnings come out as dividends. An S corporation pays no federal income tax at the entity level; profits flow straight through to shareholders, who pay once on their personal returns. Everything else — how you pay yourself, who can invest, what deductions you get, what happens to losses — flows from that single split.
How Each Entity Is Taxed
A C corporation is a separate taxpayer. It files Form 1120, reports its own income and deductions, and pays 21% federal corporate income tax on its profits.1Internal Revenue Service. Forming a Corporation When those after-tax profits are distributed as dividends, shareholders owe tax again at their individual rate. Qualified dividends are taxed at 0%, 15%, or 20% depending on income, but the underlying money has already been taxed once. That is double taxation.
An S corporation files Form 1120-S, but the return is informational.2Internal Revenue Service. About Form 1120-S, U.S. Income Tax Return for an S Corporation The entity owes no federal income tax on operating earnings. Income and losses flow through to shareholders in proportion to ownership on a Schedule K-1, and shareholders report the numbers on their Form 1040 at individual rates that top out at 37%.3Internal Revenue Service. Shareholder’s Instructions for Schedule K-1 (Form 1120-S) (2025)
The head-to-head math isn’t 21% versus 37%. If a C corporation earns $100, it keeps $79 after the corporate tax. Distribute that $79 as a qualified dividend taxed at 20%, and the shareholder nets $63.20. An S corporation shareholder earning the same $100 at the top 37% rate keeps $63. Very close. But most S corp owners aren’t in the top bracket, and they get an extra deduction the C corp cannot touch.
Payroll Tax on Owner Pay: The Everyday Driver
This is the reason most small business owners choose an S corporation. Both structures require owner-employees to draw a salary, and both pay FICA on that salary: 6.2% Social Security plus 1.45% Medicare from the employee, matched by the employer, with the Social Security portion applying on wages up to $184,500 in 2026.4Social Security Administration. What Is the Current Maximum Amount of Taxable Earnings for Social Security
The twist is what happens beyond the salary. In an S corporation, profits paid out above the salary are distributions, not wages, and distributions aren’t subject to FICA.5Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues An owner earning $200,000 who takes a $100,000 salary and $100,000 as a distribution saves roughly $15,300 in combined employer and employee FICA on the distribution portion, compared with taking the entire $200,000 as wages. In a C corporation, everything the owner is paid as compensation runs through payroll and gets hit with FICA.
The IRS is well aware of the S corp arithmetic. It requires that owner-employees receive “reasonable compensation” for their work before taking distributions. Set the salary too low and the IRS can reclassify distributions as wages, with back payroll taxes plus penalties and interest. Reasonable depends on the role, industry comparables, and the company’s revenue.
The Qualified Business Income Deduction
S corporation owners can claim the Qualified Business Income deduction under Section 199A, which allows eligible pass-through owners to deduct up to 20% of their qualified business income before figuring personal tax.6Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income The One Big Beautiful Bill Act made the deduction permanent starting in 2026. C corporations cannot claim it.
The deduction is limited at higher incomes. For 2026, single filers with taxable income above $201,750 and joint filers above $403,500 enter a phase-in range where the deduction starts shrinking. 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 paid, or 25% of W-2 wages plus 2.5% of the cost of depreciable property. Owners of specified service businesses — law, medicine, accounting, consulting — lose the deduction entirely above the upper thresholds.
For owners under the thresholds, the QBI deduction cuts the effective federal rate on pass-through income by up to 20%. Someone in the 24% bracket claiming the full deduction pays an effective rate closer to 19.2%, well below the C corporation’s combined burden.
The Section 1202 Exclusion Cuts the Other Way
The C corporation has one tax benefit that S corporations simply cannot access. Under Section 1202, shareholders selling qualified small business stock may exclude a large portion of their capital gain from federal tax.7Office of the Law Revision Counsel. 26 U.S. Code 1202 – Partial Exclusion for Gain From Certain Small Business Stock The benefit is available only for C corporation stock. S corporation shares never qualify.
For stock acquired after July 4, 2025, the exclusion works on a tiered schedule. Three years of holding gets a 50% exclusion, four years gets 75%, five years gets 100%. The maximum excludable gain per issuing company is the greater of $15 million or ten times the shareholder’s adjusted basis, and the $15 million cap will be indexed for inflation starting in 2027.
To qualify, the company must be a domestic C corporation with aggregate gross assets of $75 million or less when the stock is issued, the shareholder must acquire the stock directly from the corporation, and at least 80% of the corporation’s assets must be used in an active qualified trade or business. Several industries are excluded: health, law, engineering, accounting, consulting, financial services, performing arts, hotels, restaurants, banking, and depletion-based businesses like oil and gas. For founders and early employees of high-growth startups, this exclusion can shelter millions of dollars and often outweighs everything else on the tax scoreboard.
Net Investment Income Tax
The 3.8% Net Investment Income Tax hits individuals with modified adjusted gross income above $200,000 single or $250,000 married filing jointly, and it applies to the lesser of net investment income or the amount over the threshold.8Office of the Law Revision Counsel. 26 U.S. Code 1411 – Imposition of Tax
C corporation dividends are always investment income, so shareholders above the threshold pay the 3.8% on every dividend dollar, pushing the top effective rate on qualified dividends to 23.8% before counting the 21% corporate tax underneath.
S corporation income works differently. If the shareholder materially participates in the business, the pass-through income is not investment income and escapes the NIIT.9Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Passive S corp shareholders do owe it. For active owner-operators above the income thresholds, that 3.8% gap is a real annual difference that compounds over the life of the business.
Fringe Benefits and Retirement Contributions
C corporations give cleaner treatment for fringe benefits. Health insurance premiums, group life insurance, and similar benefits paid for an owner-employee are deductible by the corporation and excluded from the owner’s taxable income, exactly like any other employee.
S corporation owners holding more than 2% of the stock get worse treatment. The corporation can pay the premium, but it must be added to the owner’s W-2 wages as taxable income. The owner can then claim a self-employed health insurance deduction on the personal return, which partially offsets the inclusion. Group life insurance and similar welfare benefits are also taxable to greater-than-2% owners.5Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
Retirement plans use the same employee deferral limit — $24,500 for 2026 — in either structure.10Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026 The catch for S corp owners is on the employer side. Employer contributions are based on W-2 wages, and S corporation distributions do not 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 FICA also shrinks the base for employer retirement contributions. That trade-off between payroll tax savings and retirement capacity is one of the harder optimization problems in small business planning.
Retained Earnings vs. Phantom Income
A C corporation can hold after-tax profits inside the business indefinitely. Shareholders owe no additional tax until the corporation distributes. That flexibility is useful for reinvesting, building reserves, or funding acquisitions.
The guardrail is the Accumulated Earnings Tax. If the IRS decides a C corporation is stockpiling earnings mainly to help shareholders avoid dividend taxes rather than for real business needs, it can impose a 20% tax on the excess accumulation. Generally, the first $250,000 is presumptively reasonable, or $150,000 for personal service corporations in accounting, law, and consulting.12Internal Revenue Service. Publication 542 (01/2024), Corporations Beyond those levels, the corporation needs a documented plan for the cash.
S corporation earnings work the opposite way. All income is taxed to shareholders in the year it’s earned, whether the corporation distributes cash or not. This creates “phantom income”: an owner might owe tax on $150,000 of pass-through income even though the corporation kept the money to fund operations. The offsetting benefit is that undistributed income increases the shareholder’s basis in the stock, which reduces the taxable gain if the owner later sells.
Who Can Own the Stock and Raise Capital
C corporations face almost no federal restrictions on ownership. Any person, corporation, partnership, LLC, trust, or foreign entity can be a shareholder. There’s no cap on shareholder count, and the corporation can issue multiple classes of stock with different voting rights, dividend preferences, and liquidation priorities.
S corporations operate under tight constraints. The Internal Revenue Code caps total shareholders at 100, and those shareholders must generally be U.S. citizens, U.S. residents, or certain qualifying trusts and estates.13Office 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 counted as a single shareholder toward the cap.
Two specialized trusts can hold S corp stock. A Qualified Subchapter S Trust must have a single income beneficiary who receives all trust income annually. An Electing Small Business Trust can have multiple beneficiaries, but each potential current beneficiary counts as a separate shareholder toward the 100-shareholder cap.
An S corporation is also limited to a single class of stock; all shares must carry identical rights to distributions and liquidation proceeds.14Internal Revenue Service. S Corporations Voting rights can vary without breaking the rule, but any variation in economic rights creates a second class and kills the election.
This is why S corporations struggle to raise institutional capital. Venture capital and private equity funds almost always require preferred stock, which gives them a liquidation preference, anti-dilution protection, and other rights sitting above common. An S corporation can’t issue it. On top of that, most VC and PE funds are organized as partnerships or LLCs and therefore cannot hold S corporation shares at all, and foreign investors are barred outright. A C corporation faces none of these limitations and can eventually list shares on a public exchange.
What Happens to Losses
When an S corporation loses money, shareholders can deduct their share on their personal returns, but only after clearing four separate hurdles: basis in stock and direct shareholder loans, at-risk amount, passive activity rules if the shareholder doesn’t materially participate, and the annual excess business loss cap on individual returns. A key trap: a bank loan to the corporation does not give the shareholder debt basis even if the shareholder personally guarantees it. Only direct loans from the shareholder to the corporation count.
Losses blocked by the basis limit carry forward indefinitely and can be used later if basis is restored. But if a shareholder disposes of all their stock, any remaining suspended losses are permanently lost.15Internal Revenue Service. S Corporation Stock and Debt Basis That’s the exit trap for shareholders who leave without first building enough basis to absorb suspended losses.
C corporation shareholders don’t face pass-through loss limits because losses stay inside the corporation, which carries its own net operating losses forward against future corporate income. The trade-off: C corp shareholders can never use the corporation’s losses to offset their personal income from other sources.
Switching Between the Two
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 in the preceding year.16Internal Revenue Service. Instructions for Form 2553 (Rev. December 2020) For a calendar-year corporation, that’s March 15. Miss it and the IRS can still grant late election relief under Revenue Procedure 2013-30 if the corporation intended to be an S corporation, had reasonable cause, and reported income consistently as if the election were in place, provided the request is made within three years and 75 days of the intended effective date.17Internal Revenue Service. Late Election Relief
Converting from C to S triggers Built-In Gains tax exposure. Assets the C corporation held at conversion that are sold within five years of the S election may be taxed at the 21% corporate rate on the gain that existed at the conversion date.18Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains After five years, the recognition period closes. A professional appraisal at conversion is essentially required to document the exposure.
Going the other direction — revoking an S election — needs 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, it can be effective on day one of that year; otherwise it takes effect the following year. There’s no immediate corporate-level tax on appreciation from this direction. The company just starts paying 21% corporate tax and shareholders face double taxation on future distributions.
One more hazard for a converted S corporation that still holds C-era accumulated earnings and profits: if passive investment income (rents, royalties, dividends, interest, annuities) exceeds 25% of gross receipts for three consecutive years, the S election terminates automatically.19Office of the Law Revision Counsel. 26 USC 1362 – Election; Revocation; Termination
Filing Deadlines and Penalties
The two structures file on different schedules. Form 1120-S is due the 15th day of the third month after year-end — March 15 for calendar-year S corporations. Form 1120 is due the 15th day of the fourth month — April 15 for calendar-year C corporations.20Internal Revenue Service. Publication 509, Tax Calendars Both can request automatic extensions, but extensions extend the time to file, not the time to pay.
The earlier S corporation deadline matters because shareholders need Schedule K-1 to finish their personal returns. And late filing hits S corporations harder 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 corp filing the same four months late owes $10,200. The per-shareholder structure means the penalty scales with the number of owners, so an entity that once seemed like the obvious pick can turn expensive quickly if the return slips.