C Corporation vs S Corporation vs Partnership: Who Actually Pays the Tax

A partnership that earns a million dollars pays no federal income tax on it, and its partners owe tax on their shares whether or not a dollar is distributed to them. A C corporation that earns the same million pays the tax itself, and when what is left is handed out the shareholders are taxed again on the dividend. An S corporation is a corporation in every legal sense and a pass-through for tax, and it owes entity-level tax only in two situations, both of which require a C corporation somewhere in its past.

That is the whole subject. Formation, distributions, losses and the election all follow from one question: who is the taxpayer. Nothing in Gulf practice rehearses it, because Saudi Arabia taxes the non-Saudi share of a resident capital company and levies Zakat on the rest at the company's own level, with no personal income tax for anything to pass into.

REG gives Area V, Federal Taxation of Entities, 23 to 33% of the section, but the 2026 Blueprint splits the topic in a way that catches candidates out: REG's basis tasks stop at cash contributions and cash distributions, while property, liquidation and the comparison of one entity against another belong to TCP.

Who the taxpayer is

Start with the return, because the return names the taxpayer.

Entity	Files	Who pays tax on the business income	Tax when the money comes out
C corporation	Form 1120, by the 15th day of the 4th month after year end	The corporation itself	Yes: a dividend to the extent of earnings and profits
S corporation	Form 1120-S, 15th day of the 3rd month, plus a Schedule K-1 per shareholder	The shareholders, at their own rates	Usually none: it reduces stock basis first
Partnership	Form 1065, same date, plus a Schedule K-1 per partner	The partners	None until the money exceeds the partner's basis

Publication 542 puts the corporate rate in one line: "Corporations, including qualified personal service corporations, figure their tax by multiplying taxable income by 21%." Confirm it in the current edition rather than memorising it, since the Blueprint says candidates "will not be tested on their knowledge of specific tax rate percentages, amounts or limitations that are indexed to inflation."

The misleading word is "pass-through", which describes the tax and not the cash. An owner is taxed on the share reported on the Schedule K-1, distributed or not, so a profitable partnership that reinvests everything still produces a bill for partners who received nothing. The IRS puts the S corporation version plainly: shareholders "report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates", which "allows S corporations to avoid double taxation on the corporate income."

Avoid, not eliminate. The same page adds that "S corporations are responsible for tax on certain built-in gains and passive income at the entity level", and a C corporation sits behind both. The built-in gains tax reaches a corporation that used to be a C corporation, or took assets with a carryover basis from one, on gains recognised inside a five-year recognition period. The excess net passive income tax applies where the corporation holds accumulated earnings and profits at year end and "has passive investment income for the tax year that is in excess of 25% of gross receipts". A corporation born an S corporation meets neither test.

The partnership's one exception is procedural. Under the centralized partnership audit regime, which "applies to all partnerships" unless an eligible one elects out, an audit adjustment produces an imputed underpayment collected from the partnership unless it pushes the adjustment out to the partners.

Formation: the control test, and its absence

Both regimes let an owner put property in untaxed. Only one attaches a condition worth failing.

For a corporation, Publication 542 says the exchange of property for stock "is usually not taxable" if "immediately afterward you are in control of the corporation", and defines control as owning "at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock." That is a cliff, not a slope: at 80% the transfer is tax free, and at 79% the same transaction is a sale of the property to the corporation at fair value. It is also why a later contribution by an existing minority shareholder is usually taxable when the identical contribution at formation was not.

For a partnership, Publication 541 says that "usually, neither the partner nor the partnership recognizes a gain or loss when property is contributed to the partnership in exchange for a partnership interest", with no control test at all. A partner can come in at 2% on the tenth anniversary and the answer does not change. Two narrow exceptions: an investment company, and a contribution followed by a related distribution that is really a disguised sale.

Services are the trap in both. Stock issued for services is not property, so it neither escapes tax nor counts toward the 80%. Publication 541 treats the value of a capital interest transferred as payment for services as "a guaranteed payment" taxable to the partner, while a profits interest is treated differently again.

Debt is the asymmetry that runs through everything afterwards. An increase in a partner's share of partnership liabilities "is treated as a contribution of money by the partner to the partnership", says Publication 541, and a decrease "is treated as a distribution of money". Corporate debt does nothing to a shareholder's stock basis: the subject of Partnership Basis vs S Corporation Basis.

Distributions: three different questions

The same act, handing cash to an owner, is measured against a different yardstick in each regime.

Entity	Measured against	Order
C corporation	Earnings and profits first, basis second	Dividend, then a reduction of stock basis, then capital gain
S corporation	The accumulated adjustments account, then any C corporation earnings and profits, then basis	Accumulated adjustments account, previously taxed earnings, accumulated earnings and profits as a dividend, then basis
Partnership	Basis only	A return of basis, then gain once money exceeds it

Publication 542 gives the corporate sequence directly. A distribution "from either current or accumulated earnings and profits is reported to the shareholder as a dividend"; the part that is not from earnings and profits "is applied against and reduces the adjusted basis of the stock"; beyond that "the shareholder has a gain (usually a capital gain)". Earnings and profits, not retained earnings and not taxable income, is the measure, and a corporation with none can distribute cash without creating a dividend.

The S corporation order comes from the Form 1120-S instructions and matters less than it looks. A corporation that has never been a C corporation has no accumulated earnings and profits, so the middle steps are empty and the question collapses into basis: tax free until stock basis runs out, capital gain after that. Only a former C corporation carries the full sequence, and TCP adds the election that distributes accumulated earnings and profits first.

Property changes the answer for a corporation and generally not for a partnership. Publication 542: "A corporation will recognize a gain on the distribution of property to a shareholder if the FMV of the property is more than its adjusted basis." A partner, by contrast, recognises gain "only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner's interest."

What the owner pays on the way through

Income tax is not the only layer, and the second is where entity choice is argued in practice. A general partner's share of trade or business income is net earnings from self-employment: the Form 1065 worksheet removes the part allocated to limited partners, estates, trusts, corporations, exempt organisations and IRAs, and keeps guaranteed payments for services in for both. An S corporation shareholder's pro rata share is not self-employment income, which is the commercial appeal of the structure and the reason the IRS polices it: "if the shareholder received or had the right to receive cash or property, then the S corporation must determine and report an appropriate and reasonable salary for that shareholder." The same line runs through the qualified business income deduction, for which owners of partnerships and S corporations may be eligible while "income earned through a C corporation or by providing services as an employee is not eligible".

Where the losses stop

A C corporation's loss never reaches its shareholders. It stays inside as a net operating loss on the corporation's own return, one reason a start-up expecting early losses is rarely a C corporation.

A pass-through loss reaches the owner but must clear four tests in a fixed order, and the entity difference bites in the first two: a partner's basis includes a share of partnership liabilities and a shareholder's stock basis does not, and nonrecourse debt is at risk only in narrow circumstances. The ordering and the fate of each suspended amount are set out in The Order of the Loss Limitations.

The S election, and how it ends

Eligibility is a checklist and the IRS publishes it as one: a domestic corporation, with only allowable shareholders, meaning individuals, certain trusts and estates and specifically "not partnerships, corporations or non-resident alien shareholders", no more than 100 shareholders, one class of stock, and not an ineligible corporation. The election goes on Form 2553, "signed by all the shareholders". The bar on non-resident alien shareholders is the one that matters in the Gulf, because it closes the structure to almost everyone there, as How to Study REG When You Have Never Filed a US Tax Return notes.

Status ends in three ways, and the Form 1120-S instructions keep them apart. Failing any eligibility test terminates the election on the day the corporation stops being a small business corporation, mid-year, with a short year on each side. A revocation needs shareholders holding "more than 50% of the number of issued and outstanding shares of stock (including nonvoting stock)", and with no date specified takes effect at the start of that year when filed by the 15th day of the 3rd month and at the start of the next year when filed later. The passive income route bites where "for each of 3 consecutive tax years" the corporation has accumulated earnings and profits and takes more than 25% of gross receipts from passive investment income. Re-electing before the fifth tax year afterwards generally needs IRS consent.

A limited liability company is not a fourth regime, however often it is called one. The IRS treats "a domestic LLC with at least two members" as a partnership unless it files Form 8832, and "an LLC with only one member" as an entity disregarded as separate from its owner on the same condition. Its tax regime is whichever of the three it lands in.

What REG tests, and what TCP tests

The 2026 Blueprint draws the line between the two sections more sharply than most study material admits, and reading it saves weeks.

Topic	REG	TCP
Eligibility, election, revocation, termination	Area V, at Remembering and Understanding	Area III, as a planning consequence
Ordinary business income and separately stated items	Area V, both entities, including guaranteed payments	Not as a compliance computation
Owner's basis	Area V, but only cash contributions, cash distributions, operations, changes in partnership liabilities and debt repayment	Area II: noncash property, debt assumed on it, noncash distributions, partner loans
Contributions under section 351 and section 721	Not in Area V. Area II asks only for legal characteristics and the formation and termination processes	Areas II and III, computed and compared
Accumulated adjustments account	Area V: the impact of current year operations on it	Area III: the election to distribute accumulated earnings and profits instead
Cash distributions above earnings and profits	Not an Area V task	Area II, as a calculation
Choosing between the three, and liquidation	Not tested	Area III: derive and compare across entity types

TCP Area II is 30 to 40% of that section and Area III is 10 to 20%, so taking TCP as your Discipline means doing half this topic again at a higher skill level. And the AICPA Board of Examiners decided on 18 September 2025 that provisions of H.R. 1 with 2024 and 2025 effective dates "will become eligible for testing in the REG and TCP sections of the Uniform CPA Examination starting on July 1, 2026", the rest six months after they take effect. Check the edition date on any entity tax material you buy.

Where to practise this

The skill is reflexive classification: name the entity, name the taxpayer, apply the rule that belongs to it. Prepito's REG course covers Area V with practice questions, simulations and full explanations in English, and the TCP course carries the property and entity selection half. Section plans are in the CPA REG study guide and the CPA TCP study guide, and the qualification as a whole is in the CPA programme. For the computations underneath this one, read Partnership Basis vs S Corporation Basis; for the Kingdom's version of the question, Zakat or Income Tax.

CPA questions and written explanations are in English. Prepito’s interface is available in English and Arabic, and the AI tutor can respond in either language.

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This is exam preparation, not tax advice. Sources: IRS, S corporations, Publication 541, Publication 542, the instructions for Form 1120-S and Form 1065, IRS guidance on S corporation shareholder compensation, limited liability companies and the qualified business income deduction, the Blueprints effective January 2026, the AICPA notice on testing H.R. 1, and ZATCA on the Saudi Income Tax Law. Rates, filing dates and thresholds change and the Blueprints are reissued; confirm any figure against the current IRS publication and Blueprint.