Who this is for
- Founders of a new US corporation choosing its federal tax status
- Corporations with a foreign co-founder or investors in view
- Owner-operated corporations comparing how profit is taxed when paid out or kept
Not covered here
- Break-even math and reasonable salary for an existing business
- The full list of who may own S corporation shares, including visas and trusts
- Choosing between an LLC and a corporation
- Each state's S election forms and deadlines
C corp vs S corp: what is the difference?
A C corporation and an S corporation are the same company under state law; only the federal tax status differs. Every corporation is a C corporation unless it files Form 2553, signed by an officer with every shareholder's consent (and a spouse's, where the shares are community property), and meets the S corporation tests (IRS Form 2553 instructions). An LLC can elect S status too; see S corporation from day one.
| C corporation | S corporation | |
|---|---|---|
| Who pays tax on profit | The corporation, at 21% federal (26 USC 11) | Shareholders, on their own returns, whether or not the profit is paid out (26 USC 1366) |
| Profit paid out to owners | Dividends are taxed again to the owner and are not deductible by the corporation (IRS) | Distributions are generally not taxed again up to the owner's stock basis (roughly, money put in plus profit taxed to the owner, less losses and payouts) (26 USC 1368) |
| Owner who works in the business | A reasonable salary is a deductible wage (26 USC 162(a)(1)) | A reasonable salary must be paid before other distributions (IRS) |
| Losses | Stay in the corporation | Pass to owners, limited by basis |
| Qualified business income (QBI) deduction | Not available | Owners may deduct up to 20% of their share of profit |
| Section 1202 exclusion of gain when founders sell their shares | Possible if every test is met | Not available |
| Who may own shares | Anyone, any number, any share classes | Limited; see the next section |
| Federal return | Form 1120 | Form 1120-S, plus a Schedule K-1 for each shareholder (IRS) |
What makes the choice not simple: the choice is hard to reverse. Once S status ends, the corporation generally cannot elect again for five tax years without IRS consent, and a C corporation that switches later can owe built-in gains tax (26 USC 1362(g); 26 USC 1374). A foreign co-founder, investors in view, founders who want different economic rights, or a state with its own S rules can each decide the answer.
What to gather: each shareholder's name and US tax residency (and their spouse's, where marital property law applies), whether anyone will hold shares through a company, trust or fund, plans to raise money and from whom, how much profit you expect to pay out versus keep, and the states where the corporation will do business.
C corp or S corp for a small business: which fits?
The owners and the plan decide it before the tax math does.
| If | Then |
|---|---|
| An owner is a nonresident alien, or a partnership, corporation or fund will hold shares | S is not available; the corporation stays C |
| You plan to sell preferred stock to investors | C: an S election would end at the closing, and C keeps the section 1202 exclusion open |
| Founders want different payout or liquidation rights | C: S allows only one class of stock |
| All owners are US citizens or residents, an owner works in the business and most profit is paid out | S taxes that profit once; check the break-even in when an S corporation election pays off |
| Most profit stays in the business to grow | C taxes kept profit at 21% and defers the owners' tax until it is paid out |
| Early losses are expected and owners have other income | S passes losses to owners, within their basis |
Who cannot choose S corporation status?
A corporation cannot be an S corporation if any one of these is true (26 USC 1361(b)):
- More than 100 shareholders. A married couple, and members of one family, count as one shareholder.
- A shareholder that is not an individual, such as a partnership or corporation. Estates, certain trusts and some tax-exempt organizations are allowed.
- A nonresident alien shareholder.
- More than one class of stock.
- Certain banks and insurance companies, and a few other special corporations.
The tests apply every day, not only at election. If an S corporation later fails one, its election ends on that day (Form 1120-S instructions). If the break was inadvertent and is fixed within a reasonable time after it is found, the IRS can rule that the election continues, provided the corporation and every shareholder agree to the adjustments it requires (26 USC 1362(f)). For visas, trusts and LLC owners, see who can own an S corporation.
C corp vs S corp for a startup: what do investors change?
Issuing preferred stock, or taking a fund organized as a partnership or corporation as a shareholder, rules out S status. Shares with a liquidation preference or a dividend preference carry different rights to distribution and liquidation proceeds, which makes a second class of stock, and a partnership or corporation is not an eligible shareholder (26 USC 1361(b)). Not every investor rules it out: a US citizen or resident who buys common shares on the founders' terms is an eligible shareholder.
If an S corporation issues preferred stock or takes such a fund as a shareholder, it becomes a C corporation that day. That year splits into two short tax years, one as an S corporation and one as a C corporation, and the corporation generally cannot re-elect S for five tax years (26 USC 1362). For the setup steps, see forming a Delaware C corporation for a startup.
Staying a C corporation also keeps the section 1202 exclusion open. For qualified small business stock acquired after July 4, 2025 and held at least five years, up to 100% of the gain can be excluded, within a per-company cap of $15,000,000 or ten times basis, whichever is greater, if every test is met (26 USC 1202). The stock must be originally issued by a C corporation that stays one for substantially all of the holding period, so shares issued while it is an S corporation never qualify. Some fields are excluded, such as consulting, law, health, accounting and financial services. For the holding tiers, asset test and other conditions, see QSBS for founders and early employees.
What counts as a second class of stock?
A corporation has one class of stock when all outstanding shares carry identical rights to distribution and liquidation proceeds. Differences in voting rights alone do not count, so voting and nonvoting common stock is allowed (26 CFR 1.1361-1(l); 26 USC 1361(c)(4)).
The regulation tests the governing provisions: the charter, articles, bylaws, state law and binding agreements about distributions and liquidation.
- Ordinary contracts and buy-sell agreements, such as an employment agreement, lease or loan, do not count unless a principal purpose is to get around the one-class rule (for buy-sell, transfer-restriction and redemption agreements, also a price well above or below fair market value).
- Unequal payouts do not by themselves create a second class when the governing provisions give identical rights, but they are given tax effect on the facts; see S corporation disproportionate distributions.
- Debt, options and convertible notes are generally not stock, and straight debt has a safe harbor. An option or warrant counts as a second class if it is substantially certain to be exercised and its strike price is well below the share value. A convertible note counts if it works like such an option, or is really equity issued to get around the rule (26 CFR 1.1361-1(l)(4)).
Founders who want different economic rights, such as a preferred return or a liquidation preference for one of them, cannot have them in an S corporation. Pay for work can differ through salary.
C corp vs S corp for non-US citizens: what does a foreign co-founder change?
A nonresident alien cannot own S corporation shares, so the corporation stays a C corporation while that person holds stock (26 USC 1361(b)(1)(C)). The test is US tax residency, not citizenship: a nonresident alien is someone who is neither a US citizen nor a US resident under the tax rules (26 USC 7701(b)). A green card holder is a US resident for tax; a visa holder is one only after passing the days-in-the-US test, and some students, teachers and trainees do not count their days for a time. A spouse counts too: if a US shareholder's spouse is a nonresident alien with a current interest in the shares under community property law, including a foreign country's marital property law, the corporation cannot be an S corporation (26 CFR 1.1361-1(g)). One exception: a nonresident alien married to a US citizen or resident can elect with that spouse, under section 6013(g), to be taxed as a US resident on worldwide income, and then counts as a resident for this test (26 USC 6013(g); 26 CFR 1.1361-1(g)(1)(ii)). Whether a resident who claims a treaty's tie-breaker rule to be taxed as another country's resident stays eligible is unsettled; the regulations reserve that rule (26 CFR 1.1361-1(g)(2)). See who can own an S corporation.
A C corporation with a foreign owner files Form 1120. If one foreign person owns at least 25% of the vote or value at any time in the year, it also files Form 5472 for any year it has a reportable transaction, such as a loan, rent, interest or a fee, with that owner or another related party (IRS Form 5472 instructions). Dividends it pays a nonresident alien owner bear 30% US withholding unless a tax treaty lowers it: the corporation withholds when it pays, reports the payment on Form 1042-S, and owes the tax itself if it does not withhold (IRS; 26 USC 1461). See what a foreign-owned C corporation files and a company with a foreign co-owner.
Residency can change in either direction:
- The foreign founder becomes a US resident: the corporation can elect S status for a later year once every test is met, but assets that grew in value while it was a C corporation can bring built-in gains tax. See moving to the US with your US company.
- A shareholder who is not a US citizen becomes a nonresident alien, for example after leaving the US or giving up a green card: the S election ends on the first day of nonresident status, which is not always the moving date. A US citizen living abroad is never a nonresident alien, so remains an eligible shareholder.
S corp vs C corp tax advantages: which costs less when profit is paid out?
An S corporation taxes profit once, on the owner's return; a C corporation taxes it twice when paid out as dividends. Which costs less depends on the owner's bracket, the salary the work requires, state tax and how much profit stays in the business.
| Pattern | C corporation | S corporation |
|---|---|---|
| Owner salary | Deductible if reasonable; payroll tax applies | Must be reasonable; payroll tax applies |
| Profit paid out each year | Corporate tax, then dividend tax; no payroll tax on dividends | Owner's income tax once; no payroll tax on distributions above salary |
| Profit kept to reinvest | Corporate tax only, until paid out | Owners taxed now, even without cash |
In an S corporation, the IRS can reclassify distributions as wages when the owner's salary is too low for the work done (IRS). Profit above salary may qualify for the qualified business income deduction; the salary itself does not (IRS QBI deduction). For a service business such as consulting, law, health, accounting or financial services, the deduction shrinks and then disappears above an income threshold (26 USC 199A(d)). See the QBI deduction for S corporation owners.
In a C corporation, profit after salary is taxed at 21%. Qualified dividends are then taxed at capital gain rates, up to 20% (IRS Topic 404; Topic 409). The 3.8% net investment income tax can apply above income thresholds (IRS). A corporation that keeps earnings beyond its reasonable business needs can owe the accumulated earnings tax; see C corporation owner dividends.
How are early losses treated?
A C corporation's losses stay in the corporation: shareholders cannot deduct them (IRS). Newer losses carry forward to offset the corporation's own later taxable income, generally up to 80% of it each year (26 USC 172). If funding rounds raise the stake of shareholders owning 5% or more by more than 50 percentage points within three years, section 382 also caps how much of the earlier losses can be used each year (26 USC 382). See net operating losses for startups.
An S corporation's losses pass to its shareholders. Each can deduct no more than the basis of their stock plus loans they made to the corporation; the rest carries forward until basis returns (26 USC 1366(d)). Further limits can apply on the owner's return; see business losses.
Do states treat C and S corporations the same?
No. Some states need their own S election, and some tax S corporations at the corporate level. Four examples:
| Place | How it treats a federal S corporation |
|---|---|
| New York State | No automatic S status: file Form CT-6, unless investment income is over 50% of federal gross income, which makes the election mandatory (NY Tax Department) |
| New York City | No S election; S corporations pay the general corporation tax (NYC Finance) |
| New Jersey | S status follows the federal election once the corporation registers as a corporation and gives proof of federal S status and a shareholder jurisdictional consent; choosing C status instead needs every shareholder's consent (NJ Division of Taxation) |
| California | S corporations pay 1.5% on California income, against 8.84% for C corporations; both owe the $800 minimum franchise tax after their first tax year (FTB S; FTB C) |
Other states have their own rules. For forms and deadlines by state, see state S corporation elections.
When must you choose, and can you change it later?
To be an S corporation from day one, file Form 2553 no later than 2 months and 15 days after the first tax year begins. For a new corporation, that year begins on the earliest of the date it first had shareholders, first had assets, or began doing business (IRS Form 2553 instructions). Miss it and the corporation is a C corporation for that year unless late-election relief applies. See S corporation from day one and late S corporation election relief.
| Change later | What it takes | What it costs |
|---|---|---|
| S to C | Revocation consented to by holders of more than half the shares, effective from the start of the tax year if made within 2 months and 15 days of it, otherwise from the next year or a later date it names; or an event that breaks a test, such as issuing preferred stock | No new S election for five tax years without IRS consent (26 USC 1362) |
| C to S | A timely Form 2553 with every shareholder's consent | Built-in gains tax at 21% on gain already in assets at the switch, if they are sold within five years (26 USC 1374); earnings kept from the C years, with large passive income, can bring a further tax and end the election (Form 1120-S instructions); profit kept from the C years is still taxed as a dividend when paid out, after any S-year profit (26 USC 1368(c)) |
See switching an S corporation to a C corporation and switching a C corporation to an S corporation.
Example
These examples are illustrative and use US dollars.
Consulting corporation paying out all profit
One US owner earns $200,000 of profit before owner pay. The corporation's share of payroll tax on the salary is the same either way and is left out.
- As an S corporation, the owner takes a $90,000 salary with payroll tax, and $110,000 passes to the owner's return, taxed once at the owner's own rates: at an illustrative 24%, about $26,400, before any QBI deduction.
- As a C corporation with the same salary, the $110,000 bears $23,100 of corporate tax at 21%. Paying the remaining $86,900 as a qualified dividend at an illustrative 15% adds about $13,000, about $36,100 in all.
Which is lower depends on the owner's bracket, state tax and how much profit is paid out. Consulting is a specified service business, so its QBI deduction can shrink or disappear at higher income, and it is an excluded field for the section 1202 exclusion.
Software startup planning a seed round
Two founders form a corporation and expect to sell preferred stock to a fund in year two. They stay a C corporation from day one. In year two the round closes with no election to lose. If every section 1202 test is met, gain on the founders' shares held at least five years could be fully excluded, up to the per-company cap. Had they elected S, the closing would have ended the election mid-year, and shares issued while it was an S corporation could never qualify.
Two founders, one living in Brazil
Two founders each own half; one lives in Brazil, is a nonresident alien and is not married to a US citizen or resident.
- Years 1–3: S status is not available. The corporation files Form 1120 and, because a foreign person owns at least 25%, attaches Form 5472 for any year it has a reportable transaction with her, such as a loan or a fee. Any dividend paid to her bears 30% US withholding, taken by the corporation: the US has no income tax treaty with Brazil (IRS treaty list).
- Year 4: she moves to the US in spring and becomes a resident under the tax rules. Because she was a nonresident earlier in year 4, an election cannot cover year 4.
- Year 5: the corporation can be an S corporation if it files Form 2553 on time and meets every test. Built-in gains tax can apply to assets it held at the switch, and profit kept from years 1–4 is still taxed as a dividend when paid out after any S-year profit.
Different for you?
- Investors or a fund are in view: see a Delaware C corporation for a startup and startup tax help.
- You are already an S corporation and an investor is coming: see switching an S corporation to a C corporation and get corporate tax help.
- A co-founder lives outside the US: see a company with a foreign co-owner and get cross-border tax help.
- The founder lives abroad: see a Delaware C corporation for a non-resident founder and get cross-border tax help.
- Founders want different economic rights or unusual share terms: check S corporation eligibility and get corporate tax help before issuing shares.
- The business already runs and you are weighing S status: see when an S corporation election pays off.
- You elect S and need payroll for your own salary and books that track distributions: see S corporation bookkeeping and get bookkeeping help.
- You are a C corporation thinking of switching: see switching a C corporation to an S corporation.
- Your state has its own S rules: see state S corporation elections and get corporate tax help.
- You have not formed yet and an LLC is an option: see LLC or C corporation.
- You hold a professional license: see professional LLC or professional corporation.
Figures on this page
| Figure | Value | Source |
|---|---|---|
| Form 2553 ordinary election deadline File after the effective tax year begins; filing during the preceding tax year is also permitted | 2 months and 15 days | IRS: Instructions for Form 2553 Checked |
| US federal corporate income tax rate Flat rate on taxable income of domestic corporations; foreign corporations pay the same rate on effectively connected income (Instructions for Form 1120-F, Section II). | 21% | IRS: Instructions for Form 1120 Checked |
| Qualified business income deduction rate Maximum share of qualified business income before individual and business limitations | 20% Tax year 2026 | IRS: Qualified business income deduction Checked |
| QSBS exclusion for newer stock held at least five years Stock acquired after July 4, 2025; subject to all section 1202 conditions | 100% | Internal Revenue Code: Section 1202(a) Checked |
| QSBS per-issuer dollar gain limit for newer stock For stock acquired after July 4, 2025; reduced by eligible gain taken into account under section 1202(a) in prior years and older-stock gain taken into account in the same year; compare with ten times adjusted stock basis; inflation adjustment begins after 2026 | $15,000,000 Tax year 2026 | Internal Revenue Code: Section 1202(b) Checked |
| Foreign ownership that makes a US corporation a Form 5472 reporting corporation At least this share of vote or value held by one foreign person, directly or indirectly, at any time in the tax year. A single-member LLC wholly owned by one foreign person is treated as such a corporation. | 25% | IRS: Instructions for Form 5472 Checked |
| Withholding rate on US-source FDAP income paid to foreign persons Applies to the gross amount of US-source FDAP income not effectively connected with a US trade or business; a treaty may lower it. Also the rate on pay to non-resident independent contractors for services performed in the US. | 30% | IRS: Fixed, determinable, annual, or periodical (FDAP) income Checked |
| Top federal rate on most net long-term capital gain Applies above the upper 15% capital-gain taxable-income threshold; special gain categories can have different rates | 20% | IRS: Topic 409, Capital gains and losses Checked |
| Net investment income tax rate Rate on the lesser of net investment income or modified adjusted gross income above the filing-status threshold | 3.8% | IRS: Net Investment Income Tax Checked |
| Current-rule net operating loss taxable-income limit General limit on post-2017 net operating loss carryforwards applied to taxable income as defined in section 172; older losses and certain insurers have different rules | 80% | US Code: 26 USC 172(a)(2) Checked |
| Shareholder size counted for a section 382 ownership change A 5-percent shareholder holds 5% or more of the stock at any time during the testing period | 5% | US Code: 26 USC 382(k)(7) Checked |
| Stake increase that is a section 382 ownership change Increase must be more than this over the shareholders' lowest ownership during the testing period, generally 3 years | 50 percentage points | US Code: 26 USC 382(g)(1) Checked |
| New York mandatory S election investment income share An eligible federal S corporation is deemed to have elected New York S status when investment income is more than this share of federal gross income for the tax year | 50% | New York Department of Taxation and Finance: Franchise tax on S corporations Checked |
| California S corporation tax rate Tax on S corporations with California source income | 1.5% | California Franchise Tax Board: S corporations Checked |
| California C corporation income tax rate Rate for C corporations other than banks and financial institutions | 8.84% | California FTB: C corporations Checked |
| California minimum franchise tax Annual minimum for S corporations incorporated, registered or doing business in California; waived for the first taxable year of a newly formed or qualified S corporation | $800 | California Franchise Tax Board: S corporations Checked |
Primary sources
- US Code: 26 USC 1361, S corporation defined
- US Code: 26 USC 1362, election, revocation and termination
- 26 CFR 1.1361-1, S corporation defined (one class of stock)
- IRS: Instructions for Form 2553
- IRS: Instructions for Form 1120-S
- IRS: S corporations
- IRS: Corporations
- IRS: S corporation compensation and medical insurance issues
- US Code: 26 USC 11, corporate tax rate
- US Code: 26 USC 1202, qualified small business stock
- US Code: 26 USC 1366, pass-through to shareholders
- US Code: 26 USC 1368, S corporation distributions
- US Code: 26 USC 1374, built-in gains tax
- US Code: 26 USC 172, net operating loss deduction
- US Code: 26 USC 199A, qualified business income
- IRS: Withholding on specific income
- US Code: 26 USC 7701(b), resident and nonresident alien
- US Code: 26 USC 6013(g), nonresident spouse treated as resident
- US Code: 26 USC 1461, liability for withheld tax
- IRS: United States income tax treaties, A to Z
- US Code: 26 USC 382, limit on losses after an ownership change
- US Code: 26 USC 162(a)(1), reasonable salaries
- IRS: Qualified business income deduction
- IRS: Topic 404, Dividends
- IRS: Topic 409, Capital gains and losses
- IRS: Net investment income tax
- IRS: Instructions for Form 5472
- New York Department of Taxation and Finance: S corporations
- NYC Department of Finance: General corporation tax
- New Jersey Division of Taxation: S corporation procedural changes
- California Franchise Tax Board: S corporations
- California Franchise Tax Board: C corporations
About this guide
Published by Cloud Accounting under standing professional approval. This version has no separately recorded personal review. It explains general rules for the tax year shown. It is not advice for your situation.
Changes
- : First published.