Chapter 5 — S Corp vs C Corp

Chapter 5 — S Corp vs C Corp

A corporation is a separate legal “person” created by filing paperwork with the state. It has shareholders (owners), a board of directors (oversight), and officers (day-to-day operations). In a one-person small business corporation, you can be all three — the titles sound grand, but the paperwork is what matters.

Corporations come in two tax flavors: the C corporation (the default) and the S corporation (a special tax election). Same legal entity, different tax treatment — and choosing between them is one of the highest-stakes tax decisions a growing business makes. Get a CPA involved before you elect anything.

The C corporation: the default corporation

Incorporate without any special election and you have a C corporation. The company files its own tax return (Form 1120) and pays federal corporate income tax at a flat 21% (as of 2026), plus state corporate taxes where applicable.

Then you pay tax again on what you take out. A salary is deductible to the company and taxable to you like any wage. But profits distributed as dividends are not deductible to the company — and taxable to you personally. Two layers of tax on the same profit. That is double taxation.

The numbers: your C corporation earns $100,000 in profit. It pays 21% — $21,000 — leaving $79,000. Distributed as dividends, you pay personal tax — say 15% qualified-dividend rate, another ~$11,850. Total tax: roughly $32,850 on $100,000 of profit. A pass-through structure taxes that same $100,000 only once.

When does a C corp make sense? Three situations: raising venture capital or going big — investors overwhelmingly invest in C corps (usually Delaware), wanting preferred stock, clean equity structures, and foreign or institutional investors, which S corps cannot offer. Converting later is expensive and messy, so start as a C corp if you plan to raise. Reinvesting everything — if profits stay inside the company to fund growth, the 21% flat rate can beat high personal rates: a founder in the 35% bracket who leaves $200,000 in the company pays 21% instead of 35%. Fringe benefits — C corps can deduct health and group life insurance for owner-employees more generously than pass-through entities can.

For the bakery, the cleaning service, the freelance designer? A C corp is almost always the wrong choice — double taxation with none of the benefits.

The S corporation: pass-through with a payroll twist

An S corporation is a corporation that has elected special tax treatment: pass-through — the company itself generally pays no federal income tax. Profits flow to shareholders’ personal returns via Schedule K-1, taxed once. No double taxation.

So why not just use an LLC? Because of the salary requirement — both the S corp’s superpower and its trap. As an owner who works in the business, the IRS requires a reasonable salary — what you would have to pay someone else to do your job — with payroll taxes on it. Profit above that salary can be taken as distributions, not subject to Social Security and Medicare taxes. That is the entire game: salary gets payroll tax, distributions do not.

The savings, with numbers. Each netting $120,000: LLC — ~$110,800 subject to self-employment tax at ~15.3%, roughly $16,950 in Social Security/Medicare taxes, plus income tax. S corp — a reasonable salary of $70,000 draws payroll taxes (employer + employee share, ~15.3%) of roughly $10,700; the remaining $50,000 comes out as distributions with zero Social Security/Medicare tax. Savings: roughly $6,000+ a year — every year.

The honest costs: payroll service (~$500–$1,000/year), a separate tax return (Form 1120-S, CPA prep often $800–$2,000), and state quirks. That is why the rule of thumb holds: the S election usually pays off once consistent profits clear roughly $60,000–$80,000 a year.

The trap: the “reasonable salary.” The IRS watches this closely. A $20,000 salary on $150,000 of profit, with the rest as distributions, is begging for an audit — back payroll taxes, penalties, and interest. “Reasonable” means defensible: check salary data for your role in your area, document your reasoning, and when in doubt, lean higher.

Eligibility limits: 100 or fewer shareholders; shareholders generally must be US individuals — no partnerships, corporations, or nonresident aliens; and only one class of stock. For a small business owned by one person or a few US citizens, these rarely bite.

How to elect S corp status

You do not form an “S corporation” — you form a corporation (or LLC) and elect S tax treatment by filing Form 2553 with the IRS, signed by all shareholders. Deadline: generally within 2 months and 15 days of the start of the tax year — want S status for all of 2026? File by March 15, 2026. Miss it and the election takes effect the following year (the IRS often grants late-election relief — ask your CPA). An LLC files the same form; it stays an LLC legally, only its tax treatment changes.

Which to choose: decision guidance

• Just starting or testing? → Sole proprietorship. Free, instant, upgrade later.
• Real liability exposure or real revenue? (Employees, physical work, food, client sites, $40k+ profit.) → LLC. The answer for most readers of this book.
• LLC consistently profiting ~$60,000–$80,000+? → Consider the S corporation election (Form 2553). Run the numbers with a CPA — savings must beat the payroll and compliance costs.
• Raising venture capital, issuing stock options, or scaling nationally? → C corporation, probably in Delaware. Get a startup attorney.
• None of the above yet? → Stay simple. The most expensive structure is the one you pay for before you need it.

The golden rule: the best structure is the simplest one that protects what you have and does not cost more than it saves. Upgrade when the business — not the dream, the business — tells you to.

Key takeaways

• A corporation is a separate legal “person” with shareholders, a board, and officers — even if all of those are you.
• A C corporation pays 21% federal corporate tax, then shareholders pay tax again on dividends (double taxation). It fits VC-backed startups, businesses reinvesting heavily, or generous fringe benefits — not most small businesses.
• An S corporation is pass-through but requires a reasonable salary subject to payroll tax; remaining profits come as distributions free of Social Security/Medicare tax — saving thousands per year once profits are high enough.
• S corps have limits: 100 or fewer shareholders, generally US individuals only, one class of stock. The IRS audits unreasonably low S corp salaries aggressively.
• Elect S status with Form 2553 (deadline: 2 months 15 days into the tax year); an LLC can make the same election without changing its legal form.
• Decision shortcut: testing → sole prop; real risk or revenue → LLC; ~$60k+ consistent profit → consider S election; raising VC/scaling big → C corp.