C Corporation vs. S Corporation: Key Differences and Benefits

If you are forming a corporation for your small business, one of the biggest decisions you will make is whether to structure it as a C Corporation vs. S Corporation. 

This choice will impact how your business is taxed, the ability to raise capital, ownership rules, and more.

Forming a corporation provides several key tax and legal benefits over operating as a sole proprietorship or partnership.

A few major advantages include limited liability protection for business owners, potential tax savings, the ability to raise funds by issuing stock, and increased credibility with customers and vendors.

This blog explores the differences between a C Corporation vs. S Corporation to help you determine which option offers the greatest benefit for your business stage, income, and long-term vision.

C Corporations vs. S Corporations (Similarities)

When weighing the pros and cons of forming a C Corporation vs. S Corporation, it is easy to focus on taxes, but some of the most valuable benefits extend beyond your tax return. 

Both structures offer strong legal and financial protections unavailable with sole proprietorships or general partnerships.

Let’s break down the key legal and tax benefits that both S Corps and C Corps share.

Limited Liability Protection

One of the most significant benefits of forming an S Corporation or C Corporation is that it provides limited liability protection to its owners and shareholders. 

In a corporation, the owners’ personal assets are considered separate and distinct from the business’ assets and liabilities. 

This shields the shareholders from being personally responsible for the corporation’s debts and liabilities.

Separate Legal Entities

S Corps and C Corps exist as separate legal entities, distinct from their owners, under state corporation laws. 

Each corporation is considered its own legal “person,” capable of acquiring assets, incurring liabilities, entering contracts, and engaging in legal actions, such as suing and being sued. 

This separation provides continuity that persists beyond the involvement of individual owners.

No Self-Employment Tax

Owners of S Corps and C Corps, who the corporation also employs, do not have to pay self-employment tax on their share of the corporation’s profits, unlike with partnerships or sole proprietorships. 

However, they must pay income tax on any salary or wages received as an employee.

Tax Deductions for Business Expenses

As legal business entities, S Corps and C Corps can deduct typical operating expenses, such as salaries, rent, utilities, insurance premiums, and other business costs, on their corporate tax returns.

While taxed differently, S Corps and C Corps share a similar general corporate legal structure, affording their owners/shareholders limited liability protection and other corporate benefits.

C Corporations vs. S Corporations: What Are the Differences?

One of the greatest distinctions between a C Corporation vs. S Corporation is how each is taxed, which can significantly impact your bottom line.

Understanding how each entity is taxed can help determine which structure provides the most efficient strategy for retaining profits, compensating shareholders, and minimizing your overall tax burden. 

Let’s explore how these tax systems work.

C Corps Are Taxed Twice

C Corporations are considered taxable entities that are separate from their owners. 

This means C Corps face double taxation.

C Corps must file a corporate tax return (Form 1120) and pay a 21% corporate income tax rate on their profits.

When C Corp profits are distributed to shareholders as dividends, those dividends get taxed again at the personal income tax rate for each shareholder who receives them.

So, the same earnings are essentially taxed twice.

S Corps Are Taxed Only Once 

S Corporations avoid double taxation through their pass-through taxation structure.

S Corps file an informational tax return (Form 1120S) but do not pay income taxes at the corporate level.

All profits and losses from the S Corp “pass through” to the shareholders’ personal tax returns.

Shareholders report and pay tax on their share of the S Corp’s income on their individual returns at their personal income tax rates.

So, while S Corp income is still taxed, it is taxed only once at the shareholder level rather than twice, as is the case for C Corps. 

This can provide significant tax savings for smaller businesses that distribute most of their earnings.

C Corporation vs. S Corporation Tax Benefits

C Corps Can Shelter Income from Shareholders

While double taxation is a drawback, C Corporations can shelter income from being immediately taxed at the shareholder level if they choose not to distribute dividends.

By retaining profits within the corporation, shareholders can defer paying personal taxes on those earnings.

This allows C Corps more flexibility to reinvest profits into growing the business before paying dividends to shareholders. 

It can effectively leverage the 21% corporate tax rate while deferring taxes that would otherwise be payable at higher personal income tax rates.

S Corps Get Qualified Business Income (QBI) Deduction

A major tax benefit for S Corporations is the qualified business income (QBI) deduction introduced in the 2017 Tax Cuts and Jobs Act. 

This allows eligible S Corp shareholders to deduct up to 20% of their share of the corporation’s qualified business income on their individual tax returns.

For example, if an S Corp shareholder’s portion of the QBI is $100,000, they can take a $20,000 deduction (20% of $100,000), reducing the taxable amount to $80,000. 

This 20% QBI deduction can provide substantial tax savings for qualifying S Corp owners.

So, while S Corps may face higher effective tax rates in some cases due to being taxed at the individual level, the QBI deduction helps offset this for shareholders of pass-through entities, such as S Corporations.

Ownership

S Corporations

S Corporations face several restrictions on who can own shares and the overall structure of ownership:

• Limited to 100 shareholders maximum
• Shareholders must be U.S. citizens or resident aliens
• Cannot be owned by C corporations, other S Corps (with limited exceptions), partnerships, or most types of trusts
• Only allowed to have one class of stock, disregarding differences in voting rights

These strict ownership rules are required by the IRS for a corporation to elect and maintain S Corp status for tax purposes. 

The restrictions severely limit the ability of S Corps to bring in outside investors or issue different classes of stock.

C Corporations

C Corporations do not face the same ownership limitations. 

Their rules around ownership provide much more flexibility:

• No cap on the number of shareholders
• Shareholders can be individuals, other corporations, foreign investors, trusts, etc.
• Unlimited classes of stock permitted, including preferred stock with special rights
• Greater ability to raise capital from investors without violating ownership requirements

The relaxed ownership constraints give C Corps an advantage when it comes to bringing in investments and structuring ownership as the business grows. 

However, it also means profits distributed to shareholders face double taxation.

Therefore, S Corp status provides tax advantages but tighter ownership rules, while C Corps have more flexible ownership but deal with double taxation of distributed profits. 

When is an S Corp better than a C Corp?

Choosing between a C Corporation vs. S Corporation depends on various factors related to how you plan to distribute profits, the structure of your business, and potential tax savings. 

Here are the key situations where an S Corp might be the better choice:

An S Corp can be advantageous if you plan to distribute most of the profits to the shareholders. 

An S Corp can also be beneficial when the tax savings from avoiding double taxation exceed the benefits of the potentially lower corporate tax rate offered by a C Corp. 

S Corps allow income, losses, deductions, and credits to flow through to shareholders’ personal tax returns, which can result in significant tax savings, especially if the shareholders are in lower tax brackets than the C Corp’s corporate tax rate.

For example:

Consider a business with $200,000 in profits. Here’s how it breaks down for both S Corp and C Corp structures:

C Corp:

• Corporate tax (21% of $200,000): $42,000
• Remaining profit: $158,000
• If the remaining profit is distributed as dividends, shareholders pay dividend taxes (qualified dividends taxed at 15%): $23,700
• Total taxes paid: $42,000 (corporate) + $23,700 (dividend) = $65,700
• Net profit for shareholders: $134,300

S Corp:

• Profits pass through to shareholders directly
• Shareholders pay taxes at their individual tax rates
• Assuming a 24% individual tax rate: $200,000 * 24% = $48,000
• Total taxes paid: $48,000
• Net profit for shareholders: $152,000

In this example, the S Corp structure saves $17,700 in taxes compared to the C Corp structure, making it a more tax-efficient choice when most profits are distributed to shareholders.

When is a C Corp Better Than a S Corp?

A C Corp is often preferable if the business plans to reinvest a significant portion of its profits back into the company rather than distributing them to shareholders.

This reinvestment strategy benefits from the C Corp’s flat corporate tax rate of 21%, allowing more capital to be used for business growth and development without the immediate tax burden on shareholders.

If the need for regular dividend distributions to shareholders is low, a C Corp can be a good option. 

Especially for shareholders who are already subject to high marginal tax rates (30%+).

Unlike S Corps, where profits must be passed through to shareholders and taxed at individual rates, C Corps can retain earnings at the corporate level, deferring personal tax liabilities for shareholders. 

A C Corp can also be more beneficial when the tax savings from the lower corporate tax rate (21%) outweigh the benefits of the S Corp’s pass-through taxation, which taxes profits at individual income tax rates. 

This is especially true for shareholders in higher income tax brackets, where individual rates can reach up to 37%.

For example: 

Consider a business with $200,000 in profits, comparing C Corp and S Corp structures:

C Corp:

• Corporate tax (21% of $200,000): $42,000
• Remaining profit after tax: $158,000
• If profits are retained and reinvested, no immediate personal tax liability for shareholders
• Effective tax rate on profits: 21%

S Corp:

• Profits pass through to shareholders and are taxed at their individual tax rates.
• Assuming a 37% individual tax rate: $200,000 * 37% = $74,000
• Total taxes paid: $74,000
• Net profit for shareholders: $126,000
• Effective tax rate on profits: 37%

In this scenario, the C Corp structure results in a significantly lower effective tax rate (21% vs. 37%). 

It allows the business to retain more capital for reinvestment, making it a better choice when profits are not needed for immediate distribution to shareholders.

Overall, both of these corporations have their unique advantages depending on your business’s needs and goals.

It is best to consult with a tax professional who can provide tailored advice to help you make the most informed decision for your specific circumstances.

The Bottom Line

The choice between a C Corp and S Corp is an investment in your company’s future. 

Take the time to understand the potential of each structure and how it aligns with your vision. 

Both S Corps and C Corps have their own advantages and disadvantages, so the best choice depends on the business owner’s needs and goals. 

With careful consideration, you can avoid costly mistakes and set your business on a path to achieve its full potential. 

Consult a CPA to ensure you make an informed decision tailored to your unique business goals.