Your choice of business structure will have far-reaching effects on your tax planning and your ability to engage in certain wealth transfer techniques. This high-level overview of two common types of corporate entities, C corporations and S corporations, may be helpful as you evaluate how best to structure your next venture or as a quick refresher on the “rules of the road” for an existing corporation. As always, it is critical to consult with your legal and tax advisors before implementing or modifying any type of business entity.
Corporation
Corporations are one of the oldest business entity forms. The corporate structure separates the management of a business – and the associated liability - from its economic benefits. A corporation may have multiple classes of stock and has no restriction on shareholders, which may make it easier to welcome outside investment or attract talent. Be aware, however, that the profits of C-corporations are subject to two levels of taxation – first at the entity level, and then, if distributed as dividends, at the shareholder level.
You might wish to consider a corporation if you would like to welcome investment from the broadest possible range of potential investors, may be interested in engaging in an IPO at some point, or if your company would meet the requirements for qualified small business stock treatment under IRC Section 1202 (more on that below).
Formation
A corporation is formed by filing articles of incorporation with the state. Generally, businesses are incorporated in their “home state,” but in some cases, it may make sense to incorporate elsewhere. Many factors may affect your decision of where to incorporate your business, including the state law governing corporations and state taxes. Businesses that may be interested in exploring going public at some point in the future may wish to explore incorporating in Delaware, which has generally favorable and well-developed corporate law, an educated bar and the Delaware Court of Chancery, which focuses solely on business entity cases.
Once the articles of incorporation have been filed, the corporation will need to adopt a set of bylaws, elect a board of directors and corporate officers (president, COO, CFO, etc.), and issue shares of stock to the owners.
Governance
The officers of the corporation will be responsible for the day-to-day management of the corporation, subject to oversight by the board of directors. The board of directors makes major decisions regarding the direction of the business and the hiring and firing of officers. Board elections and substantial changes to the entity under state law – generally including amendments to the bylaws or the decision to merge or sell – are subject to a vote of the shareholders. In a closely held corporation, the same group of individuals may hold all of these roles.
Liability
Shareholders have no liability for the actions of the corporation. The officers and directors owe fiduciary duties of care and loyalty to the shareholders. The duty of care requires that they consider all relevant information and act on that information in the manner of a reasonably prudent person under similar circumstances. The duty of loyalty requires them to act in good faith and in the best interests of the corporation. Failure to fulfill their fiduciary duties may subject the directors and officers to liability.
In addition to potential suits by shareholders for violations of fiduciary duty, he directors and officers may also be sued by outside parties, like customers or vendors. The corporation will typically provide insurance (known as “D&O insurance”) for directors and officers to protect them against potential risk.
Tax Profile & Planning Power
Income Taxation
Corporations are subject to two levels of income taxation. Corporate profits are taxed to the corporation at the applicable corporate tax rate when earned and taxed again to the shareholder as ordinary income at their appropriate marginal rate when distributed as dividends. Following the passage of the Tax Cuts and Jobs Act in 2017, the corporate tax rate was permanently lowered to 21% (from a top rate of 35%), and the top individual rate was lowered from 39.6% to 37% through the end of 2025 (although this lower rate is likely to be extended pursuant to President Trump’s “Big, Beautiful Bill”). Corporations must file a Form 1120 Federal U.S. Corporation Income Tax Return, and shareholders must report any dividends on their Form 1040. Depending on whether and to what extent the business plans to issue significant dividends, the relatively low post-2017 corporate income tax rate may present favorable income tax planning opportunities. If the corporation does not plan to issue dividends and the taxpayer shareholders are in a higher bracket, it may make sense to consider a corporate structure to take advantage of the 21% corporate income tax rate.
Planning Opportunities
Corporations present unique planning advantages. The lack of restriction on shareholders and classes of stock makes it easier to invite outside investment or provide incentives for talent acquisition. For businesses that would like to go public at some point, corporations are effectively “IPO-ready,” as almost all public companies are corporations. In addition, corporations that meet certain requirements may qualify under IRC Section 1202 for qualified small business stock (“QSBS”) treatment, which allows for significant gain avoidance in the event of a sale.
Flexibility of Ownership Structure
A C-corporation can have an unlimited number of shareholders, and those shareholders are not subject to entity or residency restrictions. This may prove helpful if the company hopes to attract outside investment from foreign individuals or entities like venture capital and hedge funds. Corporations may have multiple classes of stock with different voting rights. The ability to incorporate different classes of stock in an incentive compensation program may prove helpful in attracting and retaining top talent. Finally, businesses organized as C-corporations have a readiness advantage when it comes to a potential IPO, as they do not have to take on the additional time and expense required to convert into an entity suitable for the capital markets.
Planning with Trusts
In 2025, the amount that an individual may transfer during their lifetime or at death without paying any gift or estate tax is $13.99 million. Owners of non-voting stock in a C-corporation may be able to leverage this gift tax exemption by transferring such shares to a trust. Because these shares lack voting rights, they may be discounted for gift tax purposes, thus allowing the owner to transfer value at a reduced gift tax cost. To provide a very simple hypothetical, if an owner has $10 million in non-voting shares of a closely-held corporation, the appraised value of these shares for gift tax purposes may be reduced for lack of control and lack of marketability to $7.5 million. If the owner transfers his non-voting shares into a properly structured irrevocable trust, he is effectively moving $10 million of value outside of his estate for a gift tax “cost” of $7.5 million. Keep in mind, however, that any such potential gift will require a qualified appraisal by a qualified appraiser and close consultation with estate planning counsel.
QSBS
Where stock in a C-corporation meets certain requirements, IRC Section 1202 provides for an exclusion from taxation upon sale of up to $10 million of capital gain or ten times the shareholder’s adjusted cost basis in stock, whichever is greater. This means, for example, that an owner of qualifying stock with an adjusted basis of $2 million that sells for $22 million would be able to exclude all $20 million of that gain.
To be eligible for “qualified small business stock” (“QSBS”) treatment, the following requirements must be met:
- The company must be a C-corporation. S-corporations and other pass-through entities do not qualify.
- The gross assets of the corporation may not exceed $50 million either before or immediately after the stock is issued.
- The corporation must be engaged in a “qualified trade or business” within the meaning of IRC 1202(e)(3). This definition excludes the following common business types, although this list is not exclusive:
- A service business relying on the reputation or skill of its employees. This means that health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, and financial services businesses will not qualify.
- Banking, insurance, finance, leasing or lending businesses.
- Farming.
- Extractive businesses, including mining and oil and gas.
- Hospitality businesses, including hotels, motels and restaurants.
- The corporation must use at least 80% of its assets in the active conduct of its qualified trade or business throughout the holding period of the stock.
- The shareholder must be an individual, trust or pass-through entity. Corporations cannot own QSBS.
- The shareholder must acquire the stock at original issuance in exchange for cash or property or as compensation. Stock acquired through options, RSUs or convertible debt will meet this requirement.
- The shareholder must hold the qualifying stock for at least five years.
In addition, the value of the exclusion from gain will be determined with reference to when the QSBS was issued. Section 1202 was first introduced in 1993 and originally allowed holders of qualifying stock to exclude 50% of their gain (on a then-current top capital gains rate of 28%). The value of the exclusion increased to 75% in 2009 and was raised further to 100% in 2010. The 100% exclusion was made permanent in 2015. Stock issued prior to the introduction of Section 1202 will not be eligible for QSBS treatment.
As noted above, the exclusion applies to up to $10 million of capital gain or ten times the shareholder’s adjusted cost basis in stock. This exclusion is per individual; there is some lack of clarity in the law as to whether spouses qualify for two exclusions or one. This may present potential planning opportunities with non-grantor trusts, which are qualified QSBS shareholders and separate “individuals” with their own exclusions. If an owner of QSBS gifts stock to a non-grantor trust, they may effectively increase the exclusion available to benefit their family. This strategy is known as “QSBS stacking.”
Keep in mind that this is a high-level summary, and there are a number of potential traps for the unwary that are beyond the scope of this article. You should consult with your estate planning counsel and your accountant regarding eligibility for QSBS status and the advisability of pursuing potential planning strategies.
S-Corporation
“S-corporation” is short for “small business corporation.” While in many respects similar to C-corporations, S-corporations are pass-through entities with a single layer of taxation. To qualify as an S-corporation, an entity must meet certain strict requirements regarding shareholder qualification and stock structure and file an S-election with the IRS. Be aware, however, that maintaining an S-election requires rigorous oversight over time. You may wish to consider structuring your business as an S-corporation if you wish to combine many of the structural features of a C-corporation with flow-through taxation.
Benefits of S-Election and Consequences of Termination
A corporation that makes and maintains an S-election will benefit from flow-through taxation for its shareholders. However, a number of strict rules govern eligibility for the S-election. Because the potential for inadvertent termination is high and you will see some variation of the words “the S-election will terminate” repeatedly in the next few sections, it may be instructive to begin with the consequences of terminating the S-election before diving into the eligibility requirements for S-corporation status.
If an S-corporation fails to meet the criteria described below, its S-election will terminate as of the date the invalidating event occurred. If the S-election terminates, the company will be treated as a C-corporation – complete with two levels of taxation - from that date forward. In this event, the corporation will have a partial year as an S-corporation and a partial year as a C-corporation for reporting purposes. Following termination, the corporation will not be eligible to make the S-election again for five years.
A company that inadvertently terminates its S-election may be eligible for relief in the form of a waiver from the IRS retroactively restoring S-status. Per the Treasury Regulations, a waiver may be available when:
- The corporation previously made a valid S-election and the election subsequently terminated;
- The termination of the election was inadvertent;
- The IRS determines that the termination was inadvertent;
- The corporation takes steps to correct the issue that resulted in the termination; and
- The corporation and its shareholders agree to make any adjustments the IRS requires to restore the S-election.
Formation
An S-corporation is formed by filing articles of incorporation at the state level. The resulting corporation must also file Form 2553, Election by a Small Business Corporation, with the IRS. This form must be signed by all shareholders. If a shareholder resides in a community property state, their spouse must also sign Form 2553; if they do not, the S-election will terminate.
Eligibility for S-Election
It is important to note that, unlike with a C-corporation, not everyone is eligible to be an S-corporation shareholder. To be eligible to make an S-corporation election, a business must be a domestic corporation in a qualified line of business with a single class of stock and no more than 100 shareholders. Certain financial institutions, insurance companies and domestic international sales companies cannot be structured as S-corporations. All members of a family (including spouses, their lineal descendants, and common ancestors within six generations) will count as a single shareholder for purposes of calculating the 100-shareholder limit.
S-corporation stock may only be owned by individuals, estates, and trusts that meet certain requirements. Partnerships, corporations, LLCs and non-resident alien shareholders are not permitted to own S-corporation stock. A non-grantor irrevocable trust will not qualify as an S-corporation shareholder unless it contains language meeting the requirements of either an “Electing Small Business Trust” or a “Qualified Subchapter S Trust” (discussed further below). Ownership by a nonqualifying shareholder will result in the termination of the S-election.
All shares of stock in an S-corporation must have identical rights to distributions and to proceeds upon liquidation. The creation of voting and non-voting stock will not be treated as violating this single class of stock requirement so long as all shares have the same economic rights. Because all shares of stock must have identical rights to distributions to qualify for S-status, a disproportionate distribution to a shareholder may terminate the S-election. S-corporations should consult with counsel before issuing debt to ensure that the debt may not potentially be recharacterized as a second class of equity, thus terminating the S-election.
Among other challenges, the shareholder eligibility requirements and the inability to offer classes of stock with different economic rights make it difficult for S-corps to grow via outside investment by foreign citizens, private equity and venture capital funds, or debt issue, and may make it more difficult to attract outside talent to serve as officers and directors. In addition, the seemingly endless number of ways to unintentionally terminate the S-election can result in uncertainty as well as significant legal and advisory expenses to “clean up” a misstep. Because many of the actions that terminate the S-election occur at the shareholder level, it is possible that the S-election may be terminated without knowledge on the part of the S-corporation itself. Given the availability of the LLC, which offers both flow-through taxation and significant additional flexibility, it is likely that S-corporations may decrease in popularity over time.
Governance and Liability
While the tax structure of S-corporations is distinct from that of C-corporations, they generally do not diverge from C-corporations with regard to the principles of governance and liability discussed above.
Tax Profile & Planning Power
Income Taxation
S-Corporations are taxed as pass-through entities, which means all items of income, deduction, loss or credit generated by the corporation are passed through to its shareholders proportionate to their ownership. The S-corporation must file a Form 1120-S informational return. The shareholder will receive a K-1 from the S-corporation and must report their share of the S-corporation’s income on their Form 1040. It’s important to note that not every state recognizes the S-election, which means that a business may be taxed as an S-corporation at the federal level and a C-corporation at the state level, which can create significant additional administrative complexity.
199A Deduction
Following the passage of the 2017 Tax Cuts and Jobs Act, S-corporation shareholders may take a deduction of up to 20% of qualified business income pursuant to IRC Section 199A. Under current law, this deduction is scheduled to “sunset” as of January 1, 2026; however, it is likely that it may be extended or made permanent as part of President Trump’s “Big, Beautiful Bill.” This deduction is also available to other pass-through entities, including partnerships and LLCs taxed as partnerships.
FICA Tax
In a partnership, all income allocable to a partner is treated as self-employment income and subject to the Federal Insurance Contributions Act (“FICA”) tax, which helps fund Social Security and Medicare. By contrast, an S-corporation will only pay FICA taxes on salaries paid to its owners. Any non-salary distributions will not be subject to FICA, potentially resulting in income tax savings. S-corporations cannot avoid FICA entirely, however – they are required to pay the owners of the business reasonable compensation for services rendered. If they fail to do so, the IRS may recharacterize some portion or all of a distribution as a salary subject to FICA.
Planning Opportunities
Planning with Trusts
As discussed above, voting and non-voting shares do not violate the single class of stock requirement. This may allow the owner of S-corporation stock to take advantage of certain gifting strategies that may reduce their overall gift tax cost, like gifting discounted non-voting shares to a qualifying trust. Remember, however, that not all trusts are qualified S-corporation shareholders. A grantor trust will qualify as an S-corporation shareholder so long as grantor trust status continues. If a trust is structured as a non-grantor trust (or becomes one by virtue of the death of, or surrender of certain powers by, the grantor of a grantor trust), it will only continue to qualify as an S-corporation shareholder if it elects to be treated as a Qualified Subchapter S Trust (“QSST”) or an Electing Small Business Trust (“ESBT”).
A QSST is a trust with a single lifetime beneficiary. The beneficiary makes an election with the IRS to treat the trust as a QSST pursuant to IRC Section 1361(d). All of the income of the trust must be distributed to the beneficiary on an annual or more frequent basis.
By contrast, an ESBT may have multiple beneficiaries, including individuals, estates and certain charitable organizations, and is not required to distribute all of its income to said beneficiaries. The trustee of the trust is responsible for making the ESBT election with the IRS pursuant to IRC Section 1361(e). While the ESBT election is generally more popular due to its flexibility, your estate planning counsel can help you determine whether a QSST or an ESBT is more appropriate for your planning goals.
QSBS
S-corporation stock is not eligible for QSBS treatment under IRC Section 1202. Further, stock issued by an S-corporation will never qualify as QSBS, even if the S-corporation subsequently converts into a C-corporation. If the shareholders of an S-corporation would like to avail themselves of QSBS status, the corporation must terminate its S-election, convert to a C-corporation, meet all other requirements for QSBS eligibility, and issue new stock that qualifies as QSBS. In some cases, it may also be possible to contribute S-corporation assets to a qualifying C-corporation. S-corporation shareholders who are interested in exploring potential routes to QSBS status should consult with their tax and legal advisors.
Charitable Planning
Public charities, donor advised funds, and private foundations are all qualified S-corporation shareholders. While contributions of appreciated property generally receive favorable charitable income tax deduction treatment, S-corporation stock may not be a preferred asset for charitable contributions for several reasons.
Like all charitable contributions of closely-held stock, S-corporation stock will need to be appraised to confirm the fair market value of the stock for charitable income tax deduction purposes. However, the value of the charitable income tax deduction for the donor will be reduced by the donor’s proportionate share of the S-corporation’s ordinary income in the event of liquidation – effectively, the transaction is treated more like a contribution of an interest in a partnership than stock in a C-corporation. Consequently, the value of the charitable income tax deduction may be lower than anticipated.
Further, S-corporation stock contributed to a charitable organization will generate unrelated business taxable income (“UBTI”) in proportion to the donated stock’s proportionate share of the income or loss generated by the S-corporation. The UBTI will be taxed to the charity (an otherwise tax-exempt organization). The charitable organization will also be liable for gain or loss on the sale of the S-corporation stock.
Charitable remainder trusts are not qualified S-corporation shareholders. Transferring S-corporation stock into a charitable remainder trust will terminate the S-election.
Instead of making a charitable contribution of their own holdings of S-corporation stock, the owners of an S-corporation may instead wish to make a contribution of cash or appreciated assets through the S-corporation itself. Because S-corporations are pass-through entities, the value of the charitable income tax deduction will flow through onto the shareholders’ personal returns proportionate to their interest in the entity. In turn, the charitable organization will receive cash or assets that do not create UBTI.
Conclusion
Understanding the nuances of corporate structures like C corporations and S corporations is an important step in aligning your business with your long-term goals. If you are considering other entity types or exploring alternatives for a different kind of venture, you may find our companion overview on limited liability companies (LLCs) and general partnerships (GPs) to be a helpful resource. As always, thoughtful planning and professional guidance are key to making informed decisions that support your broader financial objectives.
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