Tax Basics for Startups

Tax Treatment of S corporations vs C corporations

While Shareholders of S and C corporations enjoy the same limited liability protection, a key distinction is how these entities are taxed for federal income tax purposes.

Keep in mind, while a C corporaton may make an election to receive S corporation tax treatment, its legal status does not change; it remains subject to the laws of the state of incorporation.

S corporation Tax Treatment

  • Federal tax treatment of an S corporation is governed by IRC subchapter S.
  • An S corporation is a pass-through entity. This means, all items of income, deductions, credits, gains and losses flow through the entity to its shareholders via Schedule K-1. Shareholders report their K-1 items on their individual income tax return.
  • Form 1120-S, U.S. Income Tax Return for an S Corporation, is filed annually.
  • S corporation net income is taxed to S corporation shareholders even if not actually paid out to them. For example, if an S corporation has two shareholders, each with a 50% ownership interest, and the S corporation's net income is $100,000, each shareholder would include $50,000 in their individual income tax return even if the entire $100,000 is retained in the business.
  • Since an S coporation is a pass-through entity, its income is not subject to double taxation. S corporation income is taxed only at the shareholder level (with a few exceptions for older C corporations that elected to convert to S corporation tax status).
  • S corporation losses are passed through the entity to shareholders who may deduct such losses against their other sources of income.

C corporation Tax Treatment

  • Federal tax treatment of a C corporation is governed by IRC subchapter C.
  • A C corporation is not a pass-through entity, it is a tax-paying entity. Its income and losses remain at the entity level.
  • C corporations file Form 1120, U.S. Corporation Income Tax Return, annually.
  • A C corporation (or LLC) may make an election to be taxed as an S corporation by filing Form 2553 with the IRS. However, while a C orporation's tax treatment may be changed, its legal status does not change. A C corporation remains subject to the laws of the state of incorporation regardless of its tax status.
  • Undistributed C corporation income is not taxed to shareholders until distributed to them as dividends. Undistributed earnings remain in a capital account called "Retained Earnings".
  • Net income of C corporations is subject to double taxation; first at the entity level and again at the shareholder level when the income is paid out to shareholders (reported on Form 1099-DIV).
  • C corporation losses are deducted only at the entity level from corporate income of other tax periods and not passed through the entity to shareholders.
  • Capital losses of C corporations may only be deducted from corporate capital gains and not from regular corporate income. C corporation capital losses may be carried back three years and forward five years.