S Corporation vs C Corporation: Tax Treatment, Pass-Through Income, and Choosing Between Them

C Corporation Taxation: Double Taxation Explained

A C corporation is a separate taxable entity. It pays corporate income tax on its own net income at the flat 21% federal rate (post-Tax Cuts and Jobs Act). When the corporation distributes after-tax profits to shareholders as dividends, those dividends are taxed again on the shareholders' individual returns — at the preferential qualified dividend rate of 0%, 15%, or 20% depending on the shareholder's income level. This two-layer taxation is what "double taxation" means in the corporate context.

Total effective tax on a dollar of C corporation earnings paid out as dividends: 21% at the corporate level + up to 20% (plus 3.8% net investment income tax for high earners) at the individual level. For a shareholder in the top bracket, the effective combined rate approaches 40–45%. This makes dividend distributions from C corporations tax-inefficient for investors who want current income.

S Corporation Taxation: Pass-Through Treatment

An S corporation is a pass-through entity — it pays no federal income tax at the entity level. Instead, all income, deductions, credits, and losses flow through proportionally to the shareholders' individual tax returns based on their percentage ownership. Each shareholder reports their share of S corporation income on their Form 1040 and pays tax at their individual rates.

This eliminates double taxation on operating income. The shareholder pays tax once, at their individual rate. For profitable businesses in low individual tax brackets, S corporation status can produce significant tax savings compared to a C corporation paying 21% plus the shareholder paying again on distributions.

However, there is a critical payroll tax complication: shareholders who work in the S corporation must pay themselves a reasonable salary subject to FICA payroll taxes. Only after a reasonable salary is paid can remaining distributions be taken as non-payroll distributions (avoiding FICA). The IRS actively scrutinises S corporations that pay unreasonably low salaries to shift income from salary to distributions. See the complete guide on payroll tax accounting for how FICA works.

S Corporation Eligibility Requirements

S corporation status is only available to corporations that meet all of the following requirements:

• Must be a domestic corporation (incorporated in the US)
• Cannot have more than 100 shareholders
• All shareholders must be US citizens or resident aliens — no foreign shareholders, no corporate shareholders, no partnerships
• Can only have one class of stock (common stock — no preferred stock with different economic rights, though voting differences are permitted)
• Cannot be certain ineligible corporations (financial institutions, insurance companies, domestic international sales corporations)

These restrictions make S corporations impractical for businesses seeking venture capital (VCs typically use preferred stock and are often investment fund entities), businesses with foreign investors, and businesses planning complex equity structures. C corporations have none of these restrictions, which is why virtually every venture-backed startup uses C corporation structure.

Distributions and Basis Rules

Basis tracking is the most complex aspect of S corporation accounting for tax purposes. Each shareholder maintains a stock basis that is increased by their share of income and additional contributions, and decreased by their share of losses and distributions. Distributions are tax-free to the extent of the shareholder's basis — distributions in excess of basis are taxable as capital gains.

Order of basis adjustments: (1) increase for income items; (2) decrease for non-dividend distributions (but not below zero); (3) decrease for non-deductible expenses and losses. The ordering matters because it affects how much of a distribution is tax-free versus taxable.

Shareholders also have debt basis from loans they personally make to the S corporation — this additional basis allows them to deduct losses beyond their stock basis, up to the total of stock basis plus debt basis.

Using Losses as a Shareholder

S corporation losses pass through to shareholders and can offset other income on their individual return — but only up to the shareholder's combined stock and debt basis. Losses in excess of basis are suspended and carried forward to future years when the shareholder restores their basis. This at-risk limitation and the passive activity rules (which may further limit loss deductibility for inactive shareholders) can significantly restrict the practical tax benefit of S corporation losses.

Side-by-Side Tax Comparison

When C Corp Is Better, and When S Corp Wins

C corporation is typically better for: businesses seeking venture capital or institutional investors; businesses planning to go public; businesses with significant retained earnings that will be reinvested (the corporate rate may be lower than the top individual rate); and businesses with international ownership or complex equity structures.

S corporation is typically better for: small to medium businesses with simple ownership structures where owners want current income without double taxation; professional service firms (law, accounting, medical) where owners are active participants; businesses generating losses that shareholders can use on their personal returns; and businesses planning to be sold (asset sale of an S corporation can be structured more efficiently than a C corporation asset sale in many situations).