October 14, 2026
An S corp isn’t a different kind of company. It’s a federal tax election that a corporation or an LLC can make so its profits pass through to the owners instead of being taxed at the company level. It can suit a profitable business owned and run by a few US individuals. A startup that plans to raise money from venture funds or angels investing through companies should stay a C corp: funds can’t own S corp stock, and S corp stock can never qualify for the QSBS exclusion.
Key takeaways
| S corp | C corp | |
|---|---|---|
| Federal income tax | Passes through to shareholders | Taxed at the company level, then on dividends |
| Who can own it | Up to 100 US individuals and certain trusts, estates and tax-exempt organizations | Anyone |
| Classes of stock | One (voting differences allowed) | Multiple, including preferred |
| Venture capital | No | Standard |
| QSBS | Never | Possible, if the requirements are met |
A C corp pays tax on its own profits, at a flat federal rate of 21%, and stockholders pay tax again on any dividends. Most startups don’t pay dividends, so the second layer rarely applies.
An S corp generally pays no federal income tax itself. Its profits and losses pass through to the shareholders by ownership percentage, and they report them on their own returns. Two consequences surprise people. Shareholders owe tax on their share of the profit even if the company keeps the cash, sometimes called phantom income. And shareholders can deduct losses only up to their investment in the company, under rules your tax advisor can walk you through.
Individuals who are US citizens or residents, certain trusts and estates, and certain tax-exempt organizations, up to 100 shareholders. Corporations, partnerships, LLCs, venture funds and non-resident individuals can’t own S corp stock.
The company can have only one class of stock. That means every share has identical rights to distributions and liquidation proceeds. Differences in voting rights are allowed. In practice, it also means the company can’t sell preferred stock to investors or price employee common stock below what investors paid. Stock options granted to employees at fair market value generally don’t count as a second class of stock, so an S corp can have an option plan. The catch is that everyone holds the same common stock, so there’s no cheaper class for employees to buy into.
It suits a profitable, owner-operated business that pays its owners a reasonable salary through payroll and passes the rest of its profit through. Owners can save self-employment tax that way compared with an LLC taxed as a partnership. It’s a poor fit for a startup that’s losing money, plans to raise outside capital, or has a non-US founder. Whether it saves you money depends on your numbers and your state, so decide with your accountant. Some states and cities, including New York City, don’t fully recognize the S election. See S Corp vs LLC.
Venture funds are partnerships or LLCs, so they can’t own S corp stock, and their investors don’t want pass-through business income. Venture deals also depend on preferred stock, which an S corp can’t issue. The moment an ineligible shareholder acquires stock, or the company issues a second class of stock, the S election ends automatically from that date. See Why Do Venture Capitalists Prefer Delaware C-corps?
Section 1202 of the tax code can exclude some or all of the gain on qualified small business stock from federal income tax when it’s sold, if the company and the stock meet the requirements and the stock is held long enough. Only C corp stock qualifies, and stock issued while the company was an S corp never does, even after the election ends. That alone is a strong reason for a venture-track startup to avoid the election. Talk to your tax advisor about whether your stock qualifies.
To elect S status, the corporation (or LLC) files Form 2553, signed by every shareholder. It’s due no more than two months and 15 days after the start of the tax year it’s meant to take effect, or any time in the prior year. The IRS often grants relief for late elections. The company then files Form 1120-S each year.
To revoke, shareholders holding more than half of the shares consent and the company files a revocation statement with the IRS. The election also ends automatically if the company stops qualifying, for example when a fund invests.
Going from S to C ends the pass-through treatment, and the company is taxed as a C corp from then on. That switch doesn’t by itself trigger capital gains tax, but timing matters, and existing stock doesn’t become QSBS.
Going from C to S is where tax can bite. If the company sells assets that went up in value while it was a C corp, it can owe a built-in gains tax at the corporate level during the first five years as an S corp. Plan any switch with your tax advisor.
For more, see C Corp vs LLC, What Legal Structure Is Best for Your Startup? and LLC Conversion to Corporation. If you’d like help choosing or changing your structure, see our Corporation Startup Package or contact us.
