S Corp vs C Corp: Which Structure Fits Your Profit?

Three federal tax treatments, one underlying business. A single-member LLC is disregarded for federal income tax by default under Treasury Regulation Section 301.7701-3, so its owner reports the business on Schedule C and pays self-employment tax on the whole profit. That same LLC can elect to be taxed as an S corporation or a C corporation without changing anything about the entity itself, which is why the choice below is a tax election far more often than it is a reorganisation.

Rates and limits are for the 2026 tax year: the Social Security wage base is $184,500 per IRS Topic 751; the corporate rate is set by IRC Section 11(b); S corporation eligibility is in IRC Section 1361(b)(1).

There is no percentage rule, and the ones in circulation are invented. Nothing in the Code, the regulations or IRS guidance sets reasonable compensation at a share of profit — not 30%, not 50%, not a third. The IRS position is a test of where the revenue comes from: to the extent gross receipts are generated by the shareholder’s personal services, payments to that shareholder are wages; to the extent they are generated by non-shareholder employees or by capital and equipment, they are properly distributions. A contractor whose crews do the work and a consultant who is the work reach very different answers at identical profit.

Against that test the IRS lists nine factors, published on its own S corporation compensation page:

The courts have backed the IRS every time it has pressed the point. In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), an accountant paying himself $24,000 while taking roughly $200,000 in distributions had $91,044 a year recharacterised as wages. Joseph M. Grey Public Accountant, P.C. v. Commissioner, 119 T.C. 121 (2002), and Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001), reached the same place from zero-salary arrangements. The consequence is not only the recharacterised payroll tax; it is that and interest and penalties across every open year.

Two mechanical points that catch owners out. Health and accident premiums paid for a shareholder owning more than 2% are wages reported in Box 1 of the W-2, though not in Boxes 3 and 5, and the shareholder then takes the self-employed health insurance deduction above the line. And an S corporation owner cannot pay themselves on a Form 1099 — compensation for services runs through payroll or it is not compensation.

The nine factors and the source-of-gross-receipts test are the IRS’s own, published at irs.gov. The case citations are given so you can read the holdings rather than take ours; verify each independently before relying on it.

Raising your salary to satisfy one rule shrinks the deduction under another. IRC Section 199A(c)(4)(A) excludes reasonable compensation paid to the owner from qualified business income. Every dollar moved from distribution to salary therefore removes a dollar of QBI and, above the threshold, removes twenty cents of deduction with it. The One Big Beautiful Bill Act made Section 199A permanent and widened the phase-in range for tax years beginning after December 31, 2025; the sunset that used to end it after 2025 is gone.

Where the wage limitation bites, there is a crossover and it is derivable. Above the phase-in range a non-service business deducts the lesser of 20% of QBI or the greater of 50% of W-2 wages and 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property. Ignore property for a service-light business and set the two binding terms equal: with profit before owner wages of P and wages of W, 0.20 × (P − W) equals 0.50 × W when W is two-sevenths of P, about 28.6%. Below that level the wage limitation caps the deduction and paying more salary raises it. Above it, the 20%-of-QBI cap governs and paying more salary lowers it.

Two qualifications matter before anyone reaches for that number. It counts the business’s total W-2 wages, not the owner’s alone, so a company with real payroll may already clear the limitation without touching owner salary. And it is irrelevant below the threshold, where no wage test applies, and irrelevant to a specified service business above the phase-in range, where the deduction is gone whatever the payroll.

The two rules point in opposite directions, so the answer is a range rather than a point. Payroll tax argues for the lowest defensible salary. Section 199A argues, in the wage-limited case, for a higher one. Reasonable compensation sets a floor neither can go under. The practical output is a salary band supported by market data and a reason on file for the figure chosen inside it — which is a different exercise from minimising, and a much better one to be holding at examination.

2026 threshold and phase-in amounts are from Rev. Proc. 2025-32, section 4.26. The permanence and phase-in change are section 70105 of Public Law 119-21. Note separately that the 3.8% net investment income tax under IRC Section 1411 does not reach S corporation income of an owner who materially participates, because that income is not passive.

Double taxation is real, and it is smaller than the shorthand suggests. A C corporation pays 21% under IRC Section 11(b). Distribute what is left as a qualified dividend to a top-bracket shareholder and the second layer is 20% plus the 3.8% net investment income tax. Compounded, that is 1 − (1 − 0.21) × (1 − 0.238), or 39.8% — and only for a shareholder at the top of the range. For 2026 the 15% dividend rate runs to $613,700 of taxable income on a joint return and $545,500 for a single filer; below those figures the combined rate is nearer 33%. The penalty is real but it is not the 60% that gets quoted.

And it only applies to money you take out. Earnings retained inside the corporation carry the 21% and nothing more, which is the whole case for a C corporation in a business reinvesting its profit. The pass-through owner is taxed at personal rates on profit whether or not it ever reaches their bank account; the C corporation owner is not.

What Is QSBS, and What Changed on July 4, 2025?

IRC Section 1202 excludes gain on the sale of qualified small business stock — original-issue stock in a domestic C corporation meeting an active-business test. Section 70431 of the One Big Beautiful Bill Act rewrote it, and the rewrite created two tracks that both remain in force. The dividing line is the enactment date, July 4, 2025. Stock you already held on that date keeps the old rules; stock issued after it gets the new ones. If you hold both, you are on both tracks at once.

The practical reading for an owner considering a C corporation today: the new track is more generous on the cap and on company size, and it pays something at three and four years where the old rule paid nothing before five. It is also the only track available for stock issued from here, which makes the issuance date a planning date rather than an administrative one. An S corporation cannot issue qualified small business stock — Section 1202(d)(1) requires the issuer to be a C corporation — so shares issued while a company was an S corporation never qualify, and converting to C status starts a fresh holding-period clock on stock issued after the conversion rather than qualifying what shareholders already hold. (An S corporation can separately hold another company’s QSBS and pass the exclusion through to its shareholders under Section 1202(g); the two questions are often confused.) This is a reason to choose the structure early rather than on the way to a sale.

What Stops You Just Leaving the Money in the Company?

Two penalty taxes, both at 20%, both aimed exactly at that. The accumulated earnings tax under IRC Section 531 applies to earnings retained beyond the reasonable needs of the business; Section 535(c)(2) gives a minimum credit of $250,000 of accumulated earnings before it can apply, reduced to $150,000 for corporations whose principal function is services in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting. The personal holding company tax under Section 541 applies where at least 60% of adjusted ordinary gross income is passive and more than half the stock is held by five or fewer individuals (Section 542(a)).

Neither is common in an operating business with a documented growth plan. Both are live risks in a closely held company that has stopped operating and started holding investments, which is precisely what a successful company can drift into.

The C corporation case rests heavily on what happens at exit. The sale itself — asset versus stock, the Section 1202 tracks, and the alternatives where no exclusion is available — is covered under selling a business tax strategies.

Dividend rate bands for 2026 are from Rev. Proc. 2025-32, section 4.03. The Section 1202 amendments are section 70431 of Public Law 119-21; the two-track structure appears in Section 1202(a)(1), (a)(4), (a)(5) and (b)(4). The 3.8% rate is IRC Section 1411. Verify each independently before relying on it.

A holding company does one job well: it separates what you are trying to keep from what is generating the risk. The operating business signs the contracts, employs the people and attracts the claims. The holding entity owns what the operating business does not need to own — the building, the intellectual property, the equipment, the accumulated cash — and licenses or leases it back. A claim against operations reaches operating assets. That is the structure, and it is the same idea behind our entity structuring entry.

The tax case for it is narrower than the protection case, and worth stating honestly. A holding company does not by itself lower a federal tax bill. Rent and royalties paid between related entities are deductible to the payer and income to the recipient; the money moves, and unless it lands somewhere taxed differently, nothing net has happened. What the structure does buy is optionality: assets that can be sold or transferred without disturbing operations, a cleaner target when the operating business is sold, and a place to hold appreciating property outside the entity most likely to be sued.

Where it actually changes tax, it is usually one of three things. Real estate held outside the operating company can generate depreciation against rental income while the operating company deducts market-rate rent. Intellectual property held separately can be licensed across several operating entities rather than trapped in one. And on a sale, a buyer wanting assets rather than stock can often be given the operating assets while the owner keeps the real estate. None of these require a holding company — all of them are easier with one.

Three cautions. Self-rental income is recharacterised as non-passive under Treasury Regulation Section 1.469-2(f)(6) when property is rented to a business in which the taxpayer materially participates, so rent from your own operating company will not shelter passive losses. A holding company that holds mostly investments walks into the personal holding company test described above. And the separation only holds if it is observed: separate books, real leases, rent actually paid, and no commingling. A structure that exists only on paper is the one that gets disregarded when it matters.

A management company can charge a real fee for real services, and that is the whole of it. The arrangement people ask about — a second entity that invoices the operating business so income lands somewhere taxed more favourably — works only to the extent the fee is what an unrelated party would charge for the same work. IRC Section 482 lets the IRS reallocate income and deductions between businesses under common control whenever that is needed to prevent evasion or to reflect income clearly. A fee set to produce a tax answer rather than to price a service is the exact target of that authority.

Done properly it is unremarkable and useful: a shared services entity employing the administrative team across several operating companies, charging each on a documented basis, with a written agreement, an invoice trail and a fee that survives comparison to the market. Done as a label on a transfer, it produces an allocation, an underpayment and a penalty exposure.

Does a Pass-Through Entity Tax Election Still Help After the SALT Change?

For most owners at this income level, yes. More than 30 states now let a pass-through business elect to pay state income tax at the entity level. The entity deducts the payment as a business expense, which is not subject to the individual state and local tax cap, and the owner takes a state credit. The One Big Beautiful Bill Act raised that cap but also phased it back down for exactly the incomes this page is about.

The phase-down removes 30 cents of cap for every dollar of modified AGI above the threshold and stops at a floor of $10,000. On the 2026 figures, an owner with modified AGI around $606,000 is back to a $10,000 cap. That is why the entity-level election matters more, not less, to a seven-figure earner: the federal relief the cap increase offers has already been withdrawn by the time it would have helped them.

Whether the election is worth making is a state-by-state question — the rules, the deadlines and the credit mechanics all differ, and in a few states the election can leave a non-resident owner worse off. It is also an entity-level decision, which is why it belongs in this conversation rather than in the return.

Cap amounts, the 30% phase-down, the thresholds and the 2030 reversion are all in IRC Section 164(b)(6) and (b)(7), as amended by Public Law 119-21. The state count is stated as a floor; confirm your own state’s regime and deadline before electing.

Structure is a decision you make again, not one you made once. The defensible answer at formation is frequently the wrong one three years later, and the cost of never revisiting it is paid quietly every quarter. The four moves below cover almost every case, and each has a deadline that is genuinely a deadline: miss it and the election takes effect a year later than intended.

The built-in gains tax is the one that surprises people. When a C corporation elects S status, IRC Section 1374 imposes a corporate-level tax at the highest Section 11(b) rate — 21% — on gain that was already built into the assets at the date of conversion, if the corporation recognises it during the five-year recognition period. It does not apply to appreciation that accrues after conversion. In practice it means the conversion should either happen well before a sale or be priced with the tax in it, and it means a valuation at the conversion date is worth getting.

Order matters more than speed. An owner who elects S status, then discovers a C corporation was needed for a Section 1202 exit, has spent a year and created a five-year problem. An owner who forms the holding company after signing a letter of intent has moved an asset at the least convenient moment for valuation. The sequence — entity, then compensation policy, then retirement plan, then holding structure — is worth deciding before the first step, and it is worth revisiting against the dates in our tax planning checklist. Where the endpoint is a sale, it belongs in the same conversation as business exit planning rather than after it.

Election timing is set by IRC Section 1362(b); see also Form 2553. Deadlines falling on a Saturday, Sunday or legal holiday move to the next business day under IRC Section 7503. Compensation policy for the S corporation case is covered in more depth on our S-Corp reasonable salary page.