Entrepreneurs forming a new business entity often face a pivotal structural decision: Should they operate as a C Corporation or elect S Corporation status? Both entities are governed by the same foundational corporate law under the California Corporations Code, yet they differ significantly in federal tax treatment, shareholder rights, and limitations on ownership. This article explores the legal and operational distinctions between C Corporations and S Corporations with a focus on liability protections and ownership constraints relevant to California business owners.
Shared Legal Foundation: Corporate Formation and Liability Shield
Both C Corporations and S Corporations are formed under the General Corporation Law (Cal. Corp. Code §§ 100–2319)
See Corp. Code § 100
They begin as the same legal entity—a standard corporation formed by filing Articles of Incorporation with the California Secretary of State under Corporations Code § 200.
See Corp. Code § 200
The distinction arises after formation, when the shareholders of a qualifying corporation elect S Corporation status by filing IRS Form 2553 under Subchapter S of the Internal Revenue Code.
Regardless of tax classification, both C Corps and S Corps offer the limited liability shield that protects shareholders from personal responsibility for corporate debts and obligations. This includes protection from contractual claims, tort liabilities, and employment disputes—unless the corporate veil is pierced due to fraud, undercapitalization, or failure to follow corporate formalities. See Sonora Diamond Corp. v. Superior Court, 83 Cal. App. 4th 523, 538–539 (2000) (view opinion).
Ownership Structure and Restrictions
C Corporation Ownership
C Corporations impose no limit on the number or type of shareholders. This makes them ideal vehicles for:
- Venture capital and institutional investment,
- Multi-tiered ownership involving LLCs, partnerships, or other corporations,
- Multiple classes of stock (e.g., preferred vs. common shares).
There are no citizenship or residency restrictions. A C Corp may have foreign or nonresident alien shareholders without jeopardizing its structure or tax status.
C Corps may also issue incentive stock options and other equity instruments commonly used in startup funding and executive compensation. These features make C Corps the default entity for high-growth, equity-financed companies.
S Corporation Ownership
By contrast, S Corporations are subject to strict ownership limitations imposed by the Internal Revenue Code:
- No more than 100 shareholders (26 U.S.C. § 1361(b)(1)(A)),
- All shareholders must be U.S. citizens or resident individuals (26 U.S.C. § 1361(b)(1)(C)),
- Only one class of stock is permitted (voting rights may differ, but economic rights must be identical) (26 U.S.C. § 1361(b)(1)(D)).
Entities such as partnerships, corporations, or most LLCs cannot own shares in an S Corporation. These constraints create inflexibility that may be unsuitable for companies anticipating external investment or complex ownership structures.
Despite these limitations, S Corporations remain popular for closely held businesses due to their favorable pass-through taxation.
Tax Classification vs. Legal Entity
It is crucial to distinguish between a legal entity and its tax treatment:
- A C Corporation is a default classification and is taxed under Subchapter C of the Internal Revenue Code. It pays corporate income tax, and shareholders pay tax again on dividends—this is the classic “double taxation” model.
- An S Corporation is a tax election, not a distinct legal form. It allows the corporation to avoid entity-level taxation by passing income, losses, and credits directly to shareholders, who report them on their personal tax returns.
The election to be taxed as an S Corporation has no effect on the corporation’s state law liability shield or fiduciary duties under the California Corporations Code.
Liability of Shareholders and Officers
In both entity types, the corporation—not its shareholders—is liable for business obligations, unless the corporate veil is pierced.
However, officers and directors may face personal liability under the Business Judgment Rule if they breach fiduciary duties. See Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020 (2009) (view opinion).
Shareholders of either structure can also face exposure if they:
- Personally guarantee corporate debt;
- Engage in self-dealing or fraudulent transfers;
- Fail to adequately capitalize the entity or observe formalities (e.g., issuing shares, maintaining minutes, filing taxes).
Thus, liability exposure is generally a function of behavior and governance, not tax election.
Converting from S Corp to C Corp (or Vice Versa)
A corporation may revoke its S election at any time by filing with the IRS. Once revoked, the entity reverts to C Corp taxation.
Conversely, a C Corporation may elect S Corporation status if it meets the IRS eligibility criteria and all shareholders consent. However, once an S Corp status is revoked, a 5-year waiting period may apply before a new S election can be made (26 U.S.C. § 1362(g)).
Business owners considering a shift in tax classification should consult both legal and tax professionals, as unintended consequences—including built-in gains tax or passive income limitations—may arise.
Conclusion
Both C Corporations and S Corporations provide liability protection and the foundational corporate structure under California law, but they diverge significantly in terms of tax treatment and ownership flexibility. For companies seeking to raise venture capital, issue multiple classes of stock, or include foreign shareholders, the C Corporation is typically the better choice. For closely held, U.S.-based businesses prioritizing pass-through taxation, the S Corporation offers valuable advantages—provided its restrictions can be tolerated.
At Guiding Legal Counsel, APC, we help entrepreneurs and business owners form and structure their entities with an eye toward long-term governance, risk management, and tax efficiency. Whether you’re launching a new venture, restructuring an existing business, or facing shareholder disputes, our firm provides comprehensive guidance grounded in California corporate law and federal tax compliance. Contact us today to schedule a consultation and structure your business with confidence.