S Corp vs C Corp: How the Two Are Taxed

S corp vs C corp is one of the most confusing comparisons in business, largely because the names suggest two different types of company. They are not. Both are corporations with the same legal structure: shareholders, directors, limited liability. The difference is how the US tax system treats their profit. A C corp is taxed as its own taxpayer. An S corp, in general, is not; its profit passes through to its owners.

This article explains where the names come from, how each is taxed, the rules for S corp status, and which kinds of business tend to choose each. It explains the mechanism and is not legal or tax advice.

Where the names come from

The letters refer to parts of the Internal Revenue Code, the body of US federal tax law. Subchapter C sets out how corporations are taxed by default. Subchapter S, added in 1958, allows certain smaller corporations to elect a different treatment.

Every corporation starts as a C corporation for tax purposes. To become an S corporation, an eligible corporation, or an LLC that elects to be taxed as a corporation, files an election with the IRS. Nothing about its legal structure changes. Only its tax treatment does.

How a C corp is taxed

A C corporation is a separate taxpayer. It files its own federal tax return and pays corporate tax on its profit. Since 2018, following the Tax Cuts and Jobs Act of 2017, the federal corporate tax rate has been a flat 21 percent. States may add their own corporate taxes.

When the corporation distributes profit to shareholders as dividends, the shareholders pay tax on those dividends too. The same profit is therefore taxed twice: once at the corporate level and again at the shareholder level. This is what people mean by double taxation.

Double taxation is not always as costly as it sounds. Profit kept inside the company to fund growth is taxed only once, at the corporate rate, until it is distributed. That is one reason fast-growing companies that reinvest their profit often do not mind the C corp structure.

How an S corp is taxed

An S corporation generally pays no federal corporate tax. Instead, its profit, losses, deductions and credits pass through to its shareholders in proportion to their ownership. Each shareholder reports their share on their own tax return, whether or not the money is actually paid out to them.

This avoids the second layer of tax, which is the main attraction. It is similar to how a partnership or a default LLC is taxed, as described in sole proprietorship versus LLC, but with the legal structure of a corporation.

There is one rule S corp owners who work in the business need to know: the IRS expects them to pay themselves reasonable compensation for the work they do, taxed like any other wage, before taking the rest as distributions. The rules around this are specific and are an area where professional advice matters.

Who can be an S corp

S corp status is only available to corporations that meet several conditions. In broad terms, an S corporation must:

• Be a domestic US corporation, or an LLC that elects corporate tax treatment.
• Have no more than 100 shareholders.
• Have only allowable shareholders, which generally means US citizens or residents, certain trusts and estates, and not partnerships, most corporations or non-resident individuals.
• Have only one class of stock, meaning all shares carry the same rights to profits and assets, although voting rights can differ.

These rules are why S corps are mostly smaller, closely held businesses. A company that wants many shareholders, foreign investors or different classes of shares cannot qualify.

How this is taught inside Astra Trainer

The Structures direction in the Business & Finance world runs to twenty courses on ownership vehicles and how they stack, including a thirteen-lesson course on corporations that compares how LLCs, LPs, PLLCs, S corps and C corps are taxed.

The aim is to see each structure as a combination of a few choices, about liability, ownership and tax, rather than as a list of names to memorise. Lessons take about five minutes and a guide walks you through anything strange.

S corp vs C corp: side by side

Why startups usually choose C corps

If S corps avoid double taxation, why are so many well-known companies C corps? Mostly because of the ownership rules.

Venture capital funds are usually structured as partnerships and often have foreign or institutional investors, none of which can hold S corp shares. Investors also commonly want preferred shares with different rights from founders' common shares, which breaks the one-class rule. A company planning to raise outside investment therefore usually needs to be a C corp, often incorporated in Delaware because of its well-developed corporate law.

For a small business owned by a few people who take most of the profit out each year, the calculation is often different, and the S corp's single layer of tax can matter more.

Holding structures and other layers

Corporations can also own other corporations. A parent company holding shares in operating subsidiaries is a common structure, explained in what is a holding company. Because S corps generally cannot have corporate shareholders, holding structures usually involve C corps, or specific arrangements that the tax rules allow.

Why tax structures are easier in the right order

S corp and C corp only make sense once limited liability and the default LLC are clear. Learned in that order, the comparison becomes a question of two or three choices rather than a tangle of rules.

Astra Trainer is built around learning in order. Quizzes follow each topic and each course ends with a ten-question final exam, while daily quests, points and a streak keep five-minute lessons going. A Circle gives you a small group with a shared weekly goal and live sessions, useful when comparing notes with others running small businesses.

What to take from this

S corp and C corp are two US tax treatments of the same legal structure, named after Subchapters S and C of the Internal Revenue Code.

A C corp pays corporate tax, at a flat 21 percent federally since 2018, and shareholders are taxed again on dividends. An S corp generally passes profit through to shareholders, avoiding the second layer.

S corp status requires no more than 100 shareholders, generally US individual owners, and one class of stock, which is why companies seeking outside investment usually choose C corps.

Which is why the most useful way to think about S corp vs C corp is not which is better, but which fits the ownership: who owns the company now, and who will need to own it later.