C Corp vs S Corp 2026:
The Decision With a $10M Tax Hinge

Tax treatment is the core difference. A C-Corp pays 21% federal corporate tax, and shareholders pay a second layer on dividends (qualified rate up to 23.8% plus NIIT). An S-Corp passes all income through to shareholders via Schedule K-1, with no entity-level federal tax. The shareholder pays personal income tax, but saves 15.3% self-employment tax on distributions above a reasonable salary. Beyond tax, C-Corps have no shareholder limits and allow multiple stock classes; S-Corps are capped at 100 US-person shareholders with one class of stock.

QSBS stands for Qualified Small Business Stock under IRC Section 1202. A C-Corp founder who holds original-issue shares for more than five years can exclude the greater of $10M or 10x cost basis from federal capital gains tax on sale. S-Corp shares never qualify. For a startup founder, this single provision can be worth more than every other difference in the comparison combined. California does not conform to the federal exclusion.

The savings come from avoiding 15.3% self-employment tax on distributions above a defensible reasonable salary. At $200k net income with an $80k salary, the SE-tax saving is roughly $18,360. However, S-Corp compliance adds costs: payroll service ($600-1,800/yr), Form 1120-S preparation ($1,000-2,500/yr), and state franchise taxes (California alone adds $800 minimum plus 1.5% of net income). The net saving at $100k income is often $5,000-$8,000, not the headline $15,000.

IRC Section 3121 and Treasury Regulations require that S-Corp shareholder-employees pay themselves compensation that reflects what a third party would pay for the same services. The IRS uses nine factors including comparable wages, duties, time, and dividend history. There is no statutory 40/60 or 60/40 salary-to-distribution ratio. The Watson v Commissioner (8th Cir 2012) and Glass Blocks Unlimited cases both resulted in distributions being reclassified as wages when salaries were set unreasonably low.

Yes, by filing Form 2553 with shareholder consents. However, the conversion triggers a five-year built-in gains recognition window under IRC Section 1374. Assets that were appreciated at the conversion date carry that built-in gain for five years; if sold within that window, the gain is taxed at the highest corporate rate at the entity level, then again to shareholders. Get an independent appraisal of all assets at conversion date.

Yes, for federal flow-through purposes, but California imposes its own S-Corp franchise tax: 1.5% of California net income with an $800 minimum. This applies on top of the federal pass-through. For a California S-Corp with $500k net income, the state adds $7,500 in entity-level tax that a sole proprietor or single-member LLC would not pay.

Form 2553 is the IRS election form that converts an eligible domestic corporation or LLC to S-Corp tax treatment. For calendar-year filers wanting S status for the current year, file by March 15. For a newly formed entity wanting S status from inception, file within 75 days (two months and 15 days) of formation. Late elections can often be rescued under Rev Proc 2013-30 if all shareholders reported income consistent with S-Corp treatment.