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A founder forming a company, or an owner asking whether to convert, is choosing between two federal tax systems. In a C corporation the company is the taxpayer: it pays 21% on its profit, and the owner pays a second tax only when money comes out as a dividend or when the stock is sold. In a pass-through (a sole proprietorship, partnership, LLC taxed as either, or S corporation) the owner is the taxpayer: profit and loss land on the owner's return in the year they happen, whether or not cash is distributed. Neither is cheaper in the abstract. The answer comes from projecting the specific business, and this guide covers the four questions the projection has to answer.
It stays on the federal side. State tax adds a layer that depends on where the business and the owner sit, and it deserves its own treatment.
01Who controls the second layer of tax
The C corporation rate is a flat 21% under §11. What the owner pays on top depends on whether, and when, profit leaves the company. A dividend is taxed at the qualified dividend rate: for 2026, 0% up to $49,450 of taxable income for a single filer ($98,900 joint), 15% up to $545,500 ($613,700 joint), and 20% above that, plus the 3.8% net investment income tax for owners above $200,000 of income ($250,000 joint). Fully distributed profit for a top-bracket owner therefore carries about 39.8% of combined federal tax: 21% at the company, then 23.8% on the 79% that remains.
A pass-through owner at the top rate pays 37% on the same profit, less the 20% qualified business income deduction under §199A where it applies, which brings the effective rate to 29.6%, plus self-employment tax or the net investment income tax depending on the entity and the owner's role. So on profit that the owner takes out every year, the pass-through usually wins. The C corporation's advantage is control: if the profit stays in the company, the owner's layer is deferred for as long as the company keeps it, and at 21% the company has 79 cents of every dollar to reinvest rather than 63 or 70. The limit on that is the accumulated earnings tax in §531, a 20% charge on earnings retained beyond the reasonable needs of the business, softened by a credit that exempts the first $250,000 of accumulated earnings ($150,000 for a corporation in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting).
Ask Planning mode: "Client, married filing jointly, other income $150,000. The business will earn $800,000 a year before owner compensation and will distribute $200,000 a year to the owner, retaining the rest. Compare total federal tax over five years as a C corporation paying the owner a $200,000 salary with no dividends, and as an S corporation paying the same salary and distributing the remaining profit."
02Who can use the losses
A C corporation's losses belong to the corporation. They become net operating losses that carry forward and offset up to 80% of the company's taxable income in a later year. Until the company is profitable, they do nothing for anyone, and if the company never turns profitable they are never used. For a start-up that expects three years of losses funded by the founders' own money, that is three years of deductions with no one to claim them.
Pass-through losses reach the owner's return in the year they happen, where they can offset wages, investment income or a spouse's salary. That is the main reason early-stage businesses are formed as LLCs or S corporations. But the losses pass through a series of gates. The owner can deduct only up to their basis in the entity (§1366(d) for an S corporation, §704(d) for a partnership), only to the extent they are at risk under §465, only if they materially participate under the passive activity rules in §469, and for 2026 only up to $256,000 of net business loss ($512,000 on a joint return) against other income under §461(l), with the excess carried forward as a net operating loss. An owner who funds the company with loans rather than equity, or who guarantees the company's bank debt, may have less basis than they expect.
Ask Planning mode: "Two founders, each married filing jointly with $300,000 of wages from other jobs. The company will lose $700,000 in year one and $400,000 in year two, funded by $600,000 of equity from each founder, then earn $1,000,000 in year three. Compare the founders' combined federal tax over three years as an LLC taxed as a partnership and as a C corporation, showing which losses are usable in each year."
03The exit: §1202 versus a single layer of capital gain
The exit can decide the whole question. A pass-through owner who sells pays one layer of tax, at capital gain rates on most of the gain. A C corporation shareholder who sells stock also pays one layer, and for qualified small business stock under §1202 may pay none at all. The 2025 law expanded the exclusion for stock issued after July 4, 2025: 50% of the gain is excluded after three years, 75% after four, and 100% after five or more, up to the greater of $15 million per issuer (indexed after 2026) or ten times the shareholder's basis in the stock. To qualify, the company must be a C corporation with gross assets of $75 million or less at issuance and must use most of its assets in an active business; service businesses in fields such as health, law, consulting and financial services are excluded.
Two cautions. First, buyers often prefer to buy assets rather than stock, and an asset sale by a C corporation is taxed twice: once at the company on the gain, and again when the proceeds are distributed. The §1202 exclusion only helps if the deal is a stock sale. Second, the clock runs from the date a C corporation issues the stock, so an LLC that becomes a C corporation later starts the clock at conversion, not at founding, and shares issued while a company was an S corporation may not qualify at all.
Ask Planning mode: "Client, single, founder stock issued in 2026 for $50,000, company is a software business with $2,000,000 of gross assets. Compare the federal tax on a $12,000,000 stock sale in 2031 if the company is a C corporation and the stock qualifies under §1202, with the tax on the same gain from selling an S corporation."
04The cost of changing course later
The choice is sticky in one direction. Moving from a pass-through to a C corporation is usually tax-free: an LLC can elect corporate status, and an S corporation can revoke its election. Moving the other way has a price. A C corporation that elects S status keeps its corporate form, but §1374 imposes a corporate-level tax on any built-in gain that existed at conversion if the asset is sold within the following five years, so appreciated property and receivables carry a 21% charge out of the C corporation years. A C corporation that converts to a partnership or LLC is treated as liquidating: the company recognizes gain on its assets and the shareholders recognize gain on their stock, both in the same year. For a company with appreciated assets, that is the one move in this article that cannot be undone cheaply.
Ask Planning mode: "C corporation with $1,500,000 of appreciated assets and $300,000 of basis. The owner, married filing jointly, wants to elect S status in 2027 and sell the business in 2029. Estimate the §1374 built-in gains tax on the 2029 sale, and compare it with staying a C corporation and selling the stock."
05Modeling the decision
Each section above is one input into the same projection: the business modeled as a C corporation and as a pass-through, over the period the owner expects to hold it, with the owner's total federal tax as the output. The inputs are the ones a practitioner already asks for when preparing a return, plus a view of the future: projected profit or loss by year, how much the owner needs to take out, the owner's other income and filing status, credits the business expects to generate, and the planned exit and its timing. The answer changes when any of those change, which is why the choice should be revisited when the business does.
Ask Planning mode: "Client, married filing jointly, $120,000 of other household income. New business, projected profit $150,000 in year one, $400,000 in year two, $700,000 in year three, with the owner taking $150,000 a year. Compare the owner's total federal tax over three years as an S corporation and as a C corporation, and show the break-even level of annual distributions above which the S corporation wins."
06Running it in Planning mode
In the Partnertax AI Tax Assistant, turn Planning on with the toggle beside the message box (it is in beta), give the client's facts, and ask the question. Planning mode models individuals, pass-through entities and C corporations, so the same business can be run under each status with the owner's return attached, and the answer calculates federal tax from those facts with the source behind each figure listed under the answer.
When an answer is the recommendation, Save plan turns it into a plan with a PDF to send the client. Each later save adds a version, so the comparison can be rerun when the client's projections change and the two versions sit side by side in My plans.
FAQFrequently asked questions
What is the federal tax rate on a C corporation in 2026?
A flat 21% under §11. Dividends paid to individual shareholders are then taxed again at the qualified dividend rate (0%, 15% or 20% depending on the shareholder's income, plus the 3.8% net investment income tax above $200,000 of income, or $250,000 on a joint return).
Does a C corporation have to pay dividends?
No. It can retain earnings and pay only the 21% corporate tax until the shareholders sell or the company liquidates. The limit is the accumulated earnings tax in §531: 20% on earnings retained beyond the reasonable needs of the business, with a credit that exempts the first $250,000 of accumulated earnings ($150,000 for a service corporation).
Can shareholders deduct a C corporation's losses?
No. Losses stay in the corporation as net operating losses and offset up to 80% of its taxable income in later years. Losses of an S corporation or partnership pass through to the owners, subject to the basis, at-risk, passive activity and excess business loss limits.
What is the §1202 exclusion after the 2025 law?
For qualified small business stock issued after July 4, 2025, a noncorporate shareholder excludes 50% of the gain after three years, 75% after four, and 100% after five, up to the greater of $15 million per issuer or ten times the stock's basis. The company must be a C corporation with gross assets of $75 million or less when the stock is issued and must meet an active business test.
What does it cost to convert a C corporation to a pass-through later?
Converting to an S corporation keeps the corporation but exposes the appreciation that existed at conversion to a corporate-level built-in gains tax under §1374 if those assets are sold within five years. Converting to a partnership or LLC is treated as a liquidation, which triggers both layers of tax at once.
