One of These Is an Entity, the Other Is an Election
The comparison gets written everywhere as a choice between two company types, and that framing causes most of the confusion that follows. No state offers an S corporation. You file articles of incorporation, the state issues a corporation, and that corporation is taxed under subchapter C of the Internal Revenue Code by default. If it is eligible and files an election, subchapter S applies instead. The certificate on the wall does not change. The tax return does.
The IRS describes S corporations as corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Everything else about the company, the board, the officers, the bylaws, the stock ledger, the annual report to the state. Stays identical whichever way the election goes. That is why an accountant can move a company from one column to the other with a form, and a lawyer cannot.
One more complication is worth clearing up early. An LLC can make the same election. It is not a corporation under state law, but it is an eligible entity for federal classification purposes. A timely Form 2553 gets treated as an election to be classified as an association taxable as a corporation, and then as an S corporation.
So the phrase S corp, in practice, covers two very different animals: a state law corporation that elected subchapter S, and an LLC that did. This page is about what the election does. Whether it is worth making from an LLC is a different question, the arithmetic is worked through in when the S corp election actually pays for itself.
What Actually Changes When Subchapter S Applies
| Point of comparison | C corporation | S corporation |
|---|---|---|
| Federal return | Form 1120 | Form 1120-S with a Schedule K-1 per shareholder |
| Who pays the federal income tax | The corporation, at 21 percent | The shareholders, on their own returns |
| Return due date | Fifteenth day of the fourth month after year end | Fifteenth day of the third month after year end |
| Tax on distributions | Dividends taxed again to the shareholder | Generally no second layer, subject to basis |
| Losses | Trapped in the corporation, carried forward | Flow to shareholders, subject to basis and at risk limits |
| Section 199A deduction | Not available | Available on the pass through share |
| Owner compensation | Salary, taxed as wages | Reasonable salary required before distributions |
| Number of shareholders | Unlimited | 100 maximum |
| Classes of stock | As many as the charter authorizes | One, ignoring differences in voting rights |
| Foreign and entity shareholders | Permitted | Not permitted |
| Fringe benefits for a working owner | Ordinary employee treatment | A more than 2 percent shareholder is treated as a partner |
Read the table as two blocks. The first six rows are why people want the election. The last five are why they cannot have it, or regret it. A fuller walk-through of which entity files which federal return sits in federal tax returns by entity type.
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Who Is Allowed to Be an S Corporation
The eligibility rules are short, absolute and checked by nobody until something goes wrong. The IRS lists them as: be a domestic corporation. Have only allowable shareholders, meaning individuals, certain trusts and estates, and specifically not partnerships, corporations or nonresident alien shareholders. Have no more than 100 shareholders. Have only one class of stock. And not be an ineligible corporation, a category that captures certain financial institutions, insurance companies and domestic international sales corporations.
Three of those trip up real companies. The nonresident-alien bar catches any founding team with a co-founder who has not become a US resident for tax purposes. That is a common shape for software companies, and a fatal one for the election. Founders in that position should read US LLCs for foreign founders before assuming an S election is available.
The entity-shareholder bar catches anyone who wanted to hold their shares through a family LLC or a holding company. And the one-class-of-stock rule catches companies that promised an early investor a preference, because a preference is a second class.
One class of stock does not mean one shareholder agreement. The rule expressly disregards differences in voting rights, so a company can have voting and nonvoting common stock without breaking it. What does break it is a difference in the rights to distribution or liquidation proceeds. That distinction causes the single most common technical failure in small-company S elections, and it usually arrives dressed as a favor to an early backer.
How the Election Is Made, and by When
You make the election on Form 2553, signed by every shareholder. The instructions set the window: no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the preceding tax year. For a calendar-year company electing for the current year, that is March 15. Each shareholder consents by signing in column K, or on a separate consent statement. A missing consent makes the election defective, not merely late.
Missing the date is survivable. Revenue Procedure 2013-30 grants relief for a late election if you request relief within 3 years and 75 days of the effective date entered on line E, and file the form with the words FILED PURSUANT TO REV. PROC. 2013-30 written in the top margin. The full procedure, including what reasonable cause looks like and what the IRS actually wants in the statement. Is in the Form 2553 guide.
An LLC does not need to file Form 8832 first. The Form 8832 instructions are explicit: an eligible entity that timely files Form 2553 and meets the other requirements is deemed to have elected to be classified as an association taxable as a corporation. Filing both is a common and harmless error, but only the 2553 is required.
Form 8832 does matter if you want corporate taxation without subchapter S. In that case it is the only route, and the election cannot take effect more than 75 days before you file it, or later than 12 months after.
Where the C Corporation Still Wins
The pass-through column is not automatically better. Four situations tilt the other way.
Retained profit. An S corporation shareholder pays tax on their share of profit whether or not the company distributes any cash. That is a genuine hardship for a capital-hungry business. The classic phantom-income problem: a shareholder receives a K-1 for $180,000 of income and $20,000 of cash. A C corporation retaining the same profit pays 21 percent, and the shareholders pay nothing until it distributes.
Owner fringe benefits. Publication 15-B instructs employers to treat a 2 percent shareholder as you would a partner in a partnership for fringe benefit purposes. In practice, that means accident and health premiums paid for a shareholder who owns more than 2 percent go into wages, and several other exclusions do not apply. A C corporation can give a working owner the same benefit package it gives everyone else.
Ownership that subchapter S bars. Entity shareholders, foreign shareholders, more than 100 holders, and preferred stock all point the same way. If an institutional investor is a realistic possibility, the corporation should stay under subchapter C. The wider case for that is set out in LLC vs C corporation.
Section 1202 of the Internal Revenue Code. Qualified small business stock has to be stock in a C corporation. An election that switches off subchapter C for the holding period switches off that exclusion too, a large number to trade away for an annual saving on employment tax.
Losing the Election and the Five Year Bar
An election ends in one of two ways. Shareholders can revoke it deliberately, which the Form 1120-S instructions say requires the consent of shareholders holding more than 50 percent of the number of issued and outstanding shares of stock, including nonvoting stock. Or it terminates by itself the moment the corporation stops qualifying. That happens quietly, and an accountant usually discovers it a year later.
The second is the dangerous one, because the consequences are retroactive to the day the disqualifying event happened. Sell one share to a corporate shareholder in April, and the company has been a C corporation since April. That means a short-year return, an unexpected entity-level tax bill, and shareholders who already reported income that was never theirs.
Then comes the lock. Once an election terminates, the corporation can make another election only with IRS consent, for any tax year before the fifth tax year after the first tax year in which the termination took effect. Five years is a long time to sit in a tax regime you did not choose, because a share transfer was papered carelessly. You can cure an inadvertent termination with IRS consent, but curing one means a private-letter-ruling exercise, with professional fees to match.
Working Out Which One You Want
Run the eligibility gate first, because it is binary: domestic, fewer than 101 shareholders, one class of stock, no entity or foreign holders. If any answer fails, the decision is made for you, and the rest of this page is background reading.
If you clear the gate, ask what happens to the profit. Money that leaves the company every year gets taxed twice under subchapter C and once under subchapter S, the election wins here. Money that stays in the company, to buy equipment, carry inventory, or fund a build, gets taxed once at 21 percent under subchapter C, but taxed to shareholders who never received it under subchapter S, the election loses here.
Then ask what the working owners are paid. The election forces a payroll, because distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered. That means a real salary, real withholding, and the quarterly returns covered in the payroll tax returns guide. S corp reasonable salary sets out what counts as reasonable.
Five Mistakes in the C Corporation and S Corporation Decision
Mistake 1: Thinking you are choosing a legal structure
Owners who believe they formed an S corporation often cannot say which state chartered it, or where the stock ledger is. The election sits on top of an entity that still needs bylaws, a board, issued shares, and an annual report. Treating the tax status as the structure is how companies end up with no corporate records at all.
Mistake 2: Giving an early backer a preference
A promise that one investor gets paid first, or gets a fixed return before anyone else, creates a second class of stock and ends the election. Voting differences are fine. Economic differences are not. If a backer needs a preference, subchapter C is the only home for the deal.
Mistake 3: Electing and then paying no salary
Taking the whole profit as a distribution is the fact pattern the IRS litigates and wins. An officer who performs services is an employee for employment tax purposes, and the agency can recharacterize distributions as wages, with interest and penalties on the unpaid employment tax.
Mistake 4: Letting a share transfer terminate the election
Shares sold to a holding company, gifted into an ineligible trust, or transferred to a co-founder who moved abroad and lost US residency, all end the election on the date of transfer. The fix is a transfer restriction in the shareholder agreement requiring the company's consent before any transfer.
Mistake 5: Electing in a year with losses
Losses pass through to shareholders only to the extent of basis. A shareholder with no basis gets a suspended loss rather than a deduction. A company expecting two years of losses before profit often gets more from carrying those losses forward inside a C corporation than from passing them to owners who cannot use them.
Three Corporations That Chose Differently
Example one: a flooring contractor in Savannah
Cedarloom Flooring is a Georgia corporation with two shareholders who both work in the business, $2.4 million of revenue, and $340,000 of profit fully distributed every year. Under subchapter C, that profit would attract $71,400 of federal tax before either owner was paid a dividend. They elected subchapter S in the second year. They take salaries of $95,000 each, and the remaining profit reaches them once. Georgia charges $100 to incorporate and $50 a year for the registration either way, so the state cost played no part in the decision.
Example two: an optics company with a founder in Lisbon
Halcyon Optics has three founders, one of whom lives in Portugal and is a nonresident alien for US tax purposes. Their accountant modeled a $28,000 annual saving from an S election, then discovered the election was unavailable, because a nonresident alien cannot be a shareholder. They stayed a Delaware C corporation, incorporated for $109 with a $50 annual report and franchise tax on top, and priced the 21 percent entity rate into their plan. The saving was never on the table. The twelve weeks spent modeling it were the real cost.
Example three: a boatyard in Bellingham
Brightwater Marine Works clears about $600,000 a year and spends nearly all of it on travel lifts, dock work, and a paint shed. The two shareholders draw modest salaries and leave the rest inside. Under subchapter S, they would have paid personal tax on roughly $600,000 of income while receiving very little cash. So they stayed under subchapter C, paid $126,000 of federal tax at 21 percent, and kept the rest working. A Washington corporation costs $180 to form with a $70 annual report, again, identical either way.
The Penalties When an Election Goes Wrong
Three numbers are worth carrying around.
The first is the late return. Revenue Procedure 2025-32 sets the penalty for a late S corporation return under section 6699 at $260 per shareholder per month, for returns required to be filed in 2027, and the same $260 per partner per month for a late partnership return. A four shareholder company that files its Form 1120-S five months late owes $5,200, on a return that may report no tax at all.
The second is the failed election. A corporation that expects pass-through treatment, misses the Form 2553 window, and does not qualify for relief gets taxed under subchapter C for the whole year. On $400,000 of profit, that is $84,000 of federal tax at 21 percent nobody budgeted for, plus the shareholder-level tax when the money comes out.
The third is the terminated election. A company that breaks the one class of stock rule in March finds itself a C corporation from March. It files a short-year return and cannot elect again for five tax years without IRS consent. Take the flooring contractor above: five years of losing pass-through treatment on $340,000 of profit is roughly $357,000 of entity-level federal tax that would not otherwise have been paid, all from a single badly drafted side letter.
Where to Read Next
If you have an LLC rather than a corporation, and the question is whether the election is worth the payroll it forces, the arithmetic is in when the S corp election actually pays for itself. If the real subject is outside investment, read LLC vs C corporation. For a plain description of the S corporation itself, start at what is an S corp. For the pass through side of an unelected LLC, the LLC taxes guide and the single member LLC guide carry the detail.
If you have not incorporated at all yet, LLC vs sole proprietorship is the earlier decision, and LP vs LLP vs LLC covers the partnership forms.
C Corporation vs S Corporation FAQ
Is an S corporation a type of business entity?
No. Subchapter S is a federal tax election. The entity underneath is a corporation formed under state law, or in some cases an LLC. Either way, the state register shows a corporation or an LLC, and the letter S appears nowhere on the formation document.
What is the main difference between a C corporation and an S corporation?
Where the tax is paid. A C corporation computes and pays its own federal income tax at 21 percent, and shareholders are taxed again on dividends. An S corporation generally pays no federal income tax itself. It passes income, losses, deductions, and credits through to its shareholders on Schedule K-1.
Who can be a shareholder in an S corporation?
The IRS requires that the only shareholders be individuals, certain trusts, and estates. Partnerships, corporations, and nonresident alien shareholders are not permitted. The corporation must be domestic, it can have no more than 100 shareholders, and it can have only one class of stock.
When is Form 2553 due?
No more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the preceding tax year. A late election can still get relief under Revenue Procedure 2013-30, if you request it within 3 years and 75 days of the effective date entered on line E.
Does an LLC have to file Form 8832 before Form 2553?
No. The Form 8832 instructions state that an eligible entity which timely files Form 2553 and meets the S corporation requirements is deemed to have elected to be classified as an association taxable as a corporation. One form does both jobs.
Can an S corporation go back to being a C corporation?
Yes. Shareholders holding more than half of the issued and outstanding shares, including nonvoting shares, can consent to revoke the election. Going back the other way is the hard direction: a corporation whose election terminated generally needs IRS consent to elect again before the fifth tax year after the termination took effect.
Why would a profitable company stay a C corporation?
Because it wants to keep the money inside the business, or because it cannot qualify for subchapter S. Retained profit is taxed once at 21 percent, and never again until the company distributes it. And a company with an entity shareholder, a foreign shareholder, more than one class of stock, or investors who want section 1202 stock has no S election available to it.
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