How C corporations and S corporations differ in taxation, ownership rules and paperwork, what an S election requires, how owners are paid and which questions to ask your accountant.
C corporation and S corporation are tax classifications, not different types of company under state law. Both start as a corporation formed under state law (or, for an S corporation, sometimes an LLC). Every corporation is a C corporation for federal tax purposes unless it files an election to be taxed under Subchapter S of the Internal Revenue Code.
To record clock-ins, breaks and overtime automatically, see EZTime time and attendance software.
So the question “C corp or S corp?” is really: should this business’s profits be taxed at the company level, or passed through to its owners? The answer affects how much tax is paid, how owners are paid and who can invest.
A C corporation files its own federal income tax return, Form 1120, and pays federal corporate income tax on its taxable profit at a flat rate, currently 21 percent. Many states add a corporate income or franchise tax.
When the corporation distributes profits to shareholders as dividends, the shareholders pay tax on those dividends on their personal returns. This is the “double taxation” C corporations are known for. In practice, many small C corporations pay owners mainly through salaries, which are deductible to the corporation, and retain earnings to grow the business, which reduces the effect.
C corporations can have any number of shareholders, including other companies and foreign investors, and can issue different classes of stock. That is why most venture-funded startups are C corporations.
An S corporation generally does not pay federal income tax itself. It files an informational return, Form 1120-S, and gives each shareholder a Schedule K-1 showing their share of income, deductions and credits. Shareholders report those amounts on their own returns and pay tax at their individual rates, whether or not the profits are actually distributed.
One reason small business owners choose S corporation status is self-employment tax. In a sole proprietorship or default LLC, the owner generally pays self-employment tax on all net earnings. In an S corporation, owners who work in the business are paid wages, on which payroll taxes apply, and remaining profits passed through to them are generally not subject to self-employment tax. The IRS requires those wages to be reasonable for the work performed, so this is not a way to avoid payroll taxes entirely.
Some states do not recognize S corporation status or impose their own entity-level tax, so check state rules too.
| C corporation | S corporation | |
|---|---|---|
| Federal income tax | Corporation pays tax on profits; shareholders taxed on dividends | Generally no entity-level tax; income passes through to shareholders |
| Federal tax return | Form 1120 | Form 1120-S plus Schedule K-1 for each shareholder |
| Number of shareholders | Unlimited | Generally up to 100 |
| Who can own shares | Individuals, companies, foreign investors | Generally US citizens and residents, certain trusts and estates; not partnerships, corporations or nonresident aliens |
| Classes of stock | Multiple classes allowed | One class (differences in voting rights alone are allowed) |
| Owner pay | Salary and dividends | Reasonable salary through payroll, plus distributions |
| Typical fit | Businesses raising outside capital or reinvesting profits | Profitable small businesses with a few owners who work in the business |
To become an S corporation, an eligible corporation or LLC files Form 2553 with the IRS, signed by all shareholders. To take effect for the current tax year, the form generally must be filed no more than two months and 15 days after the beginning of that tax year, or at any time during the preceding tax year. The IRS has relief procedures for late elections in some situations.
An LLC that wants S corporation treatment can file Form 2553 directly; it is treated as having elected to be taxed as a corporation. See Form 8832 for the separate entity classification election.
Elections can be lost if the business stops meeting the requirements, for example by admitting an ineligible shareholder, so keep ownership changes under review.
Once a business elects S corporation status, owners who provide services to it are generally treated as employees for payroll purposes. That means:
All the questions answered. Time to talk to your accountant.
If you are moving from a sole proprietorship to an S corporation, this is often the biggest practical change. See our guide to common payroll errors to avoid the usual mistakes.
Most of the C corp versus S corp decision comes down to a handful of IRS rules:
The signature rule trips up more owners than the shareholder limit. If one co-owner is traveling or reluctant, the election cannot be filed. Collect signatures early, and keep a copy of the filed form and the IRS acceptance letter with the corporate records.
These are questions for a tax adviser who knows your numbers. The right answer can change as the business grows.
Many small businesses start as sole proprietorships or single-member LLCs, then elect S corporation status once profits grow. Others form a C corporation from the start because they plan to raise capital. Whatever you choose, the day-to-day work of hiring, scheduling and paying employees stays the same. Our guide to the cost of hiring an employee helps you budget as the team grows.
A C corporation pays federal income tax on its profits, and shareholders pay tax again on dividends. An S corporation generally passes income through to shareholders, who pay tax on their personal returns, avoiding the corporate-level income tax in most cases.
Yes. An eligible LLC can elect to be taxed as an S corporation by filing Form 2553. Its legal structure under state law remains an LLC.
Generally up to 100, and they must be eligible shareholders, such as US citizens or residents and certain trusts and estates. Family members can be treated as one shareholder in some cases.
Owners who work in the business generally must be paid reasonable compensation through payroll before taking distributions. What is reasonable depends on their duties and what similar businesses pay.
Generally no more than two months and 15 days after the start of the tax year the election should take effect, or any time in the preceding year. Late election relief may be available in some circumstances.
Generally yes. An S corporation passes its income, losses, deductions and credits through to shareholders, who report them on their personal returns, so corporate income is not taxed a second time at the corporate level the way a C corporation’s is. Some states treat S corporations differently, so check your state too.
A C corporation can make sense when you plan to raise venture capital, want to issue more than one class of stock, expect to have more than 100 shareholders or non-qualifying shareholders, or plan to keep profits in the business. These are tax and legal decisions, so review them with an advisor.
If you run payroll as an S corporation, EZTime keeps hours and schedules for every employee in one place and exports reports in Excel or PDF for your payroll provider.