Choosing the right business structure can affect how a company is taxed, how owners receive income, who can own shares, and how the business raises capital. Two common corporate structures in the United States are S corporations (S corps) and C corporations (C corps).

Although both provide a separate legal structure from their owners, their federal tax treatment and ownership requirements are significantly different. Understanding these differences can help small-business owners evaluate which structure better fits their business plans.

What Is an S Corporation?

An S corporation is a corporation that elects special tax treatment under Subchapter S of the Internal Revenue Code. For federal income tax purposes, an S corporation generally passes income, losses, deductions, and credits through to its shareholders instead of paying regular federal corporate income tax on those amounts. Shareholders generally report their share of the business's income on their individual tax returns.

To qualify for S corporation status, a company must meet specific IRS requirements. Generally, it must be a domestic corporation, have no more than 100 shareholders, have only eligible shareholders, and have only one class of stock. Certain corporations, such as some financial institutions and insurance companies, are not eligible. The business generally makes the S corporation election by filing Form 2553 with the IRS.

Because of these restrictions, S corporation status may not fit every growing company.

What Is a C Corporation?

A C corporation is treated as a separate taxpayer for federal income tax purposes. The corporation reports its income and expenses, calculates its taxable income, and generally files Form 1120, U.S. Corporation Income Tax Return.

Unlike an S corporation, a C corporation can generally have a broader range of shareholders and can issue different classes of stock. This structure can provide greater flexibility for companies seeking outside investment and planning for substantial growth.

One important tax consideration is that corporate profits can be taxed at the corporate level, and dividends paid to shareholders can also be taxable to the shareholders. The IRS describes this as double taxation.

S Corp vs. C Corp: Key Differences

State tax treatment can differ, so business owners should also review the rules in the states where the business operates. The SBA notes that states do not all treat S corporations in exactly the same way.

How Taxes Differ Between S Corp and C Corp

Tax treatment is one of the biggest differences between the two structures.

With an S corporation, business income generally passes through to shareholders and is reported on their individual tax returns. The company generally does not pay regular federal income tax at the corporate level, although certain S corporations can be subject to specific entity-level taxes.

S corporation owners who work for the business also need to understand payroll requirements. Corporate officers who perform services for an S corporation are generally treated as employees for federal employment-tax purposes, and compensation for those services must generally be treated as wages.

A C corporation is taxed separately from its shareholders. If the corporation distributes after-tax profits as dividends, shareholders may also have taxable dividend income.

The actual tax result depends on the company's income, deductions, owner compensation, distributions, state taxes, and other circumstances.

Ownership and Stock Differences

Ownership flexibility is another major distinction.

S corporations have strict federal ownership rules. They generally cannot have more than 100 shareholders, and partnerships, corporations, and nonresident aliens generally cannot be shareholders. An S corporation is also generally limited to one class of stock.

C corporations have fewer federal restrictions on shareholder eligibility and can generally use multiple classes of stock. This can be important for businesses considering different types of investors, employee equity arrangements, or significant future fundraising.

For a small business planning to remain closely held, these restrictions may be manageable. For a business expecting outside investment or more complex ownership arrangements, the differences can become more important.

Which Structure Fits a Small Business?

There is no single structure that works for every business.

An S corporation may be considered by eligible businesses that want pass-through federal tax treatment and can operate within the applicable ownership and stock restrictions. A C corporation may be considered by businesses that want greater flexibility in ownership, stock structure, and raising capital.

Business owners should also consider factors such as expected profits, plans to reinvest earnings, owner compensation, shareholder changes, state tax treatment, and future financing needs.

For example, a closely held service business with a limited number of eligible owners may evaluate S corporation taxation, while a company planning to seek outside investors may place greater importance on the flexibility of a C corporation.

S Corp vs. C Corp: Questions to Ask Before Choosing

Before selecting a tax structure, consider:

• How many owners or investors will the business have?
• Does the business expect to seek outside investment?
• Will profits generally be distributed or reinvested?
• Are all proposed shareholders eligible for S corporation status?
• Will the owners actively work in the business?
• What are the federal and state tax consequences?
• Could the ownership structure change as the company grows?

Because tax and entity rules can vary depending on the company's circumstances and state, business owners should review the structure with qualified tax and legal professionals.

Final Thoughts

The difference between an S corporation and a C corporation goes beyond the way a business files its tax return. S Corp vs. C Corp decisions can affect federal tax treatment, ownership eligibility, stock structure, payroll requirements, distributions, and future growth plans.

An S corporation generally provides pass-through federal income tax treatment but comes with specific shareholder and stock restrictions. A C corporation offers broader ownership and stock flexibility but is generally subject to corporate-level taxation, with potential additional taxation when dividends are distributed.

Before making a change or forming a new business, review your expected income, ownership plans, investment strategy, and state tax considerations. Professional tax advice can help you understand how the choice applies to your specific business circumstances.

Source: Internal Revenue Service and U.S. Small Business Administration guidance on S corporations, C corporations, taxation, and business structures.