Choosing the right business structure can have a major impact on how much you pay in taxes, how you take money out of your business, and how you plan for future growth. Two structures that business owners often compare are the S Corporation (S Corp) and C Corporation (C Corp). They may both provide liability protection, but the way they're taxed is dramatically different. Understanding those differences can help you choose a structure that supports your business today without creating expensive tax problems down the road.
Understanding S Corps and C Corps
Both S Corps and C Corps can provide liability protection for their owners when properly established and maintained. However, there's an important distinction between the two.
A C Corporation is the default federal tax treatment for a corporation. The corporation is a separate taxpayer and generally files its own federal income tax return on Form 1120. The corporation pays tax on its taxable income, and if after-tax profits are later distributed to shareholders as dividends, those shareholders may also owe tax on the dividends. That's where the term "double taxation" comes from.
An S Corporation, on the other hand, is a federal tax election available to qualifying corporations and LLCs. Generally, the business itself doesn't pay federal income tax on its operating profits. Instead, income, losses, deductions, and credits pass through to the shareholders, who report their respective shares on their individual tax returns.
That's a critical point. An S Corp isn't necessarily a different type of legal entity. It's a tax election. An LLC can elect S Corporation taxation while continuing to operate legally as an LLC.
Key Tax Advantages
One of the biggest reasons I love the S Corporation for the right small business owner is the potential payroll tax savings.
If you're actively working in your S Corp, you generally need to pay yourself a reasonable salary, which is subject to payroll taxes. But once you've paid yourself reasonable compensation, additional business profits may generally be distributed to you without being subject to Social Security and Medicare payroll taxes. That's where the savings can become significant.
But don't fall for the idea that you can form an S Corp, pay yourself a tiny salary, and take everything else as distributions. The IRS requires reasonable compensation for the work you perform, and getting too aggressive can create unnecessary audit exposure, back payroll taxes, penalties, and interest.
A C Corp works differently. The corporation currently pays a 21% federal corporate income tax rate on its taxable income. That can make the structure attractive in certain situations, particularly when a company plans to retain and reinvest profits rather than distribute all of its earnings to shareholders.
C Corps can also provide valuable planning opportunities involving employee fringe benefits, equity compensation, raising capital, and potentially Qualified Small Business Stock (QSBS). For founders building a company with a significant future exit in mind, those considerations can be just as important as the current year's tax bill.
Drawbacks to Consider
For a C Corp, double taxation can be a significant disadvantage, particularly for closely held businesses whose owners expect to regularly distribute profits. The corporation may first pay tax on its income, and shareholders can then owe tax when those after-tax earnings are distributed as dividends.
An S Corp avoids that traditional double-taxation structure, but it comes with its own restrictions.
S Corporations generally:
- Cannot have more than 100 shareholders
- Cannot have nonresident aliens as shareholders
- Generally cannot have corporations, partnerships, or most other entities as shareholders
- Can have only one class of stock, although differences in voting rights are permitted
- Must allocate income, losses, and distributions according to ownership interests rather than creating the flexible economic arrangements commonly available in partnerships
These restrictions can make an S Corp a fantastic structure for a closely held operating business but a poor fit for a company planning to bring in certain outside investors or issue multiple classes of equity.
Which Structure Is Best for You?
The choice between an S Corp and a C Corp depends on much more than which one has the lowest tax rate.
If you're operating a profitable small or medium-sized business and taking much of the income out of the company, an S Corp may provide valuable payroll tax planning opportunities while maintaining pass-through taxation.
On the other hand, if you're building a company that plans to raise outside capital, issue equity, retain significant earnings for growth, or pursue a substantial future exit, a C Corp may offer advantages that an S Corp simply can't provide.
And don't make this decision based solely on the 21% C Corp tax rate. A lower entity-level tax rate doesn't necessarily mean a lower overall tax bill once you consider how and when you're going to get that money out of the corporation.
It's also possible to change your tax or entity structure as your business evolves, but that doesn't mean changing is always simple or tax-free. Depending on the direction of the conversion, the assets involved, and your particular circumstances, restructuring can create significant tax and legal consequences.
The Bottom Line
Choosing between an S Corp and C Corp isn't about finding the structure that's universally "best." It's about choosing the structure that fits how you make money, how you plan to take that money out, who will own the business, and where you want the company to go. An S Corp can create significant payroll tax savings for the right closely held business, while a C Corp can open doors to investors, equity strategies, reinvestment, and potential exit-planning opportunities. The expensive mistake is choosing based on one tax rate or one piece of advice without looking at the entire strategy.
My team at KKOS Lawyers helps business owners look at the entire picture before choosing or changing an entity, including taxes, liability protection, ownership, payroll, and long-term growth plans. The wrong structure can cost you thousands in unnecessary taxes and become much harder to unwind as your business grows. Book a comprehensive consultation with my team at KKOS Lawyers and make sure your business is built on the right foundation before an avoidable mistake gets expensive.
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Frequently Asked Questions
What is the biggest tax difference between an S Corp and a C Corp?
An S Corp generally passes its income, losses, deductions, and credits through to its shareholders, while a C Corp is a separate taxpayer that pays corporate income tax. C Corp shareholders may also owe tax when corporate profits are distributed as dividends.
Does an S Corp pay a 21% corporate tax?
Generally, no. The 21% federal corporate income tax rate applies to C Corporations. An S Corp generally passes its taxable income through to its shareholders, who pay tax at their applicable individual rates.
Can an LLC be an S Corp?
Yes. An LLC that meets the eligibility requirements can elect to be taxed as an S Corporation while remaining an LLC under state law.
Does an S Corp eliminate self-employment or payroll taxes?
No. An owner who performs services for the S Corp generally must receive reasonable compensation as wages, and those wages are subject to applicable payroll taxes. However, additional S Corp profits distributed to the shareholder generally aren't subject to Social Security and Medicare payroll taxes in the same way wages are.
Why would someone choose a C Corp instead of an S Corp?
A C Corp may be more appropriate for a business that wants to raise institutional or venture capital, have a broader range of shareholders, issue different classes of stock, retain earnings for growth, provide certain employee benefits, or potentially qualify shareholders for QSBS treatment.
Can you switch from an S Corp to a C Corp later?
Yes, but changing tax status can have important tax and legal consequences. Don't assume you can simply flip a switch later without considering how the change affects the company and its shareholders.
This version also pairs nicely with the LLC vs. C Corp article we just updated. I'd internally link the two because someone researching one comparison is very likely to need the other.
