What Is an S Corporation (S Corp)?
An S corp or S corporation is a business structure that is permitted under the tax code to pass its taxable income, credits, deductions, and losses directly to its shareholders. That gives it certain advantages over the more common C corp, The S corp is available only to small businesses with 100 or fewer shareholders, and is an alternative to the limited liability company (LLC).
Both S corps and LLCs are known as "pass-through entities" because they pay no corporate taxes. Instead, they pay their shareholders, who are responsible for the taxes due.
Key Takeaways
- An S corporation or S corp, also known as an S subchapter, is one type of legal business structure common among small business. A limited liability company (LLC) is another.
- Requirements of an S corp give a corporation with 100 shareholdersor less the benefit of incorporation while being taxed as a partnership.
- Both S corps and LLCs are pass-through entities, meaning that they don’t pay corporate taxes, and both offer limited liability protection for their owners/principals. However, LLCs are more flexible.
- S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations.
- LLCs aren’t subject to the same Internal Revenue Service (IRS) rules governing the number and type of members, who are typically sole proprietors or small groups of professionals.
Understanding an S Corporation (S Corp)
S corporations get their name from Subchapter S of the Internal Revenue Code, under which they’ve elected to be taxed. The key characteristic of a corporation filed under Subchapter S: It may pass business income, losses, deductions, and credits directly to shareholders, without paying any federal corporate tax—making it something known as a pass-through entity. This gives it some special tax benefits under 2017’s Tax Cuts and Jobs Act. However, it is liable on the corporate level for taxes on specific built-in gains and passive income.
Aside from its tax status, an S corp is similar to any other corporation, or C corporation as they’re officially known. It’s a for-profit company, incorporated under and governed by the same state corporation laws. It offers similar liability protection, ownership, and management advantages as a C corporation.
It must also observe internal practices and formalities that include:
- having a board of directors
- writing corporate bylaws
- conducting shareholders’ meetings
- keeping minutes of significant company meetings
The main difference between an S corp and a C corp is how each is taxed: Profits from a C corp are taxed to the corporation when earned, then taxed to the shareholders when distributed as dividends, creating a double tax. An S corp may pass income directly to shareholders without having to pay federal corporate taxes.
IRS Requirements for an S Corp
To qualify for S corporation status, a business has to meet certain Internal Revenue Service (IRS) requirements. It has to be incorporated domestically (within the United States), have only one class of stock, and not have more than 100 shareholders. In addition, those shareholders must meet certain eligibility requirements, which means that they must be individuals, specific trusts and estates, or certain tax-exempt organizations [501(c)(3)]. Partnerships, corporations, and nonresident aliens cannot qualify as eligible shareholders.
S corp shareholders report income, gains, and losses from the corporation on their individualtax returns, and they pay taxes at their ordinary income tax rates. Since the money comes to them free of corporate tax, they avoid double taxation on any income or earnings from the corporation.
How to Set up an S Corp
To create an S corporation, a business must first be incorporated.
It then must file Form 2553 with the IRS. Known officially as Election by a Small Business Corporation, the form states that the IRS will accept the S corp status only if the business meets all the qualifications for the status, “all shareholders have signed the consent statement, an officer has signed below, and the exact name and address of the corporation (entity) and other required form information have been provided.”
Advantages and Disadvantages of S Corporations
Advantages of Registering as an S Corp
- Corporate tax savings. Businesses that register as an S corp benefit from not having to pay federal taxes at the entity level. Saving money on corporate taxes is beneficial, especially when a business is in its early years.
- Personal income tax savings. S corp status can also lower the personal income tax tab for the business owners. By characterizing money they receive from the business as salary or dividends, S corp owners often lower their liability for self-employment tax. The S corp status generates deductions for business expenses and wages paid to their employees.There are also tax benefits for pass-through entities that apply to S corp owners.
- Corporate dividends. S corp shareholders can be company employees, earn salaries, and receive corporate dividends that are tax free if the distribution does not exceed their stock basis. If dividends exceed a shareholder’s stock basis, the excess is taxed as capital gains—but these are taxed at a lower rate than ordinary income.
- Simplified asset transfers. Other advantages include being able to transfer interests or adjust property bases without facing adverse tax consequences or having to comply with complex accounting rules.
- Help establish credibility. S corporation status may help establish credibility with potential customers, employees, suppliers, and investors by showing the owner’s formal commitment to the company.
Disadvantages of Registering as an S Corp
- IRS scrutiny. The IRS scrutinizes how S corps pay their employees because S corporations can disguise salaries as corporate distributions to avoid paying payroll taxes. An S corporation must pay reasonable salaries to shareholder-employees for services rendered before any distributions are made.
- Restricted distribution rules. When making those distributions to stakeholders, the S corp must allocate profits and losses based strictly on the percentage of ownership or number of shares each individual holds.
- Subject to approval and removal of status by the IRS. On rare occasions, the IRS may terminate an S corp’s Subchapter S status if an S corp either doesn’t properly allocate profits and losses or makes any other noncompliance moves, such as mistakes in an election, consent, notification, stock ownership, or filing requirement. However, a quick rectification of noncompliance errors can usually avert any adverse consequences.
- Takes time and money. The business of setting up an S corp requires time and money. The business owner must submit articles of incorporation with the Secretary of State in the state where their company is based. The corporation must obtain a registered agent for the business and pay other fees associated with incorporating itself.
- Fees. In many states, owners pay annual report fees, a franchise tax, and other miscellaneous fees. However, the charges are typically inexpensive and may be deducted as a cost of doing business. Also, all investors receive dividend and distribution rights, regardless of whether the investors have voting rights.
- Limits on growth. The limits on the number and nature of shareholders might prove onerous for a business that’s growing rapidly and wants to attract venture capital or institutional investors.
Pros
Tax benefits: no or lesser corporate and self-employment tax for owner, no double taxation for shareholders
Protections of incorporation: limited liability, transfer of interests
Prestige, credibility
Cons
Costs of incorporation
Complex compliance rules
Potentially growth-inhibiting qualifications to maintain status
S Corp vs. LLC
A limited liability company (LLC) is another type of legal business entity. Like the S corp, it’s a common go-to structure for small businesses.
LLCs and S corps share other characteristics as well. Both are pass-through entities, meaning that they don’t pay corporate taxes, and both offer limited liability protection for their owners/principals, meaning that the owners’ personal assets can’t be touched by business creditors, nor can they be held personally responsible in lawsuits filed against the company. As a pass-through entity, LLC owners also have tax benefits under the Tax Cuts and Jobs Act, just as S corp owners do.
However, LLCs are more flexible than S corps. They aren’t subject to the IRS regulations concerning the number and type of shareholders/owners (called “members”) or to other federal or state rules regarding governance, procedure, and distribution of funds. They can allocate their profits and losses in whatever proportions the owners desire.
Note
Easier to establish than S corps, LLCs typically are formed by sole proprietors or small groups of professionals, like attorneys, doctors, or accountants. However, their financing options are more limited—generally, to bank loans, as opposed to equity investors. This can limit their potential for growth.
U.S. Income Tax Return for an S Corporation
Although they are largely exempt from corporate taxes, S corporations must still report their earnings to the federal government and file tax returns.
Form 1120-S is essentially an S corp’s tax return. Often accompanied by a Schedule K-1, which delineates the percentage of company shares owned by each individual shareholder, Form 1120-S reports the income, losses, dividends, and other distributions that the corporation has passed onto its shareholders.
Unlike C corps, which must file quarterly, S corps only file once a year, like individual taxpayers. Form 1120-S is simpler than tax forms for C corporations, too. The version for 2022 ran five pages.
As long as a company elects S corporation status (and the IRS has accepted that election), it must file Form 1120-S. The form is due by the 15th day of the third month after the end of its fiscal year—generally, March 15 for companies that follow a calendar year.
Like individuals, S corporations can request a six-month extension to file their tax returns. To do so, they must file Form 7004: Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns by their return’s regular due date.
Why Would You Choose an S Corporation (S Corp)?
S corporations combine the benefits of corporations with the tax advantages of partnerships. They offer the limited liability protection of the corporate structure—meaning that an owner’s personal assets can’t be accessed by business creditors or legal claims against the company. But like partnerships, they don’t pay corporate taxes on any earnings and income that they generate. They can also help owners avoid self-employment tax.
How Does an S Corp Work?
In many ways, an S corp works as any corporation does. Operating under its home state’s corporation statutes, it establishes a board of directors and corporate officers, bylaws, and a management structure. It issues shares of company stock. Its owners cannot be held personally or financially liable for claims by creditors or against the company.
What Is the Difference Between an S Corp and a C Corporation (C Corp)?
C corps pay corporate taxes on their earnings, the way individuals pay income taxes. (In the U.S., corporations are currently taxed at a flat rate of 21%.) Any dividends or other profits are then distributed to shareholders with after-tax funds. S corps, by contrast, are generally exempt from federal tax on most earnings, so they can distribute more gains to stockholders. In return for this tax benefit, S corps face certain IRS-mandated restrictions.
The Bottom Line
S corporations are a common type of legal entity recommended for small businesses. They carry the tax advantages of partnerships while providing the limited liability protections of corporations. Sort of a “corporate lite” structure, they are easy to establish and simpler to maintain than regular C corporations.
S corps require many of the protocols and incur many of the costs associated with regular corporations—starting with the fees and formalities associated with incorporation. They are definitely more expensive to establish and time consuming to maintain than LLCs, another popular small-business structure.
Though advantageous for fast-growing firms, they are also subject to certain restrictions on their size and shareholders by the IRS, which could eventually inhibit their expansion. The good news is that it’s relatively easy for an S corp to change to C corp status, should business conditions prove favorable to do so.
