What Is an S Corporation and Should You Form One

  • Accracy
  • 26th Nov, 2023

Some corporations are eligible for a special tax designation called "S corporation" status, which exempts them from paying corporate income taxes.

What Is an S Corporation and Should You Form One
Starting a Business

What is an S corporation?

"S corporation" stands for "Subchapter S corporation", or sometimes "Small Business Corporation." It's a special tax status granted by the IRS (Internal Revenue Service) that lets corporations pass their corporate income, credits and deductions through to their shareholders.

Generally speaking, S corporations don't pay federal income tax. Rather, they're what's called a "pass-through entity." Their income (or losses) are "passed through" to the company's individual shareholders to split up amongst each other (reported on a Schedule K-1) and report it on their own personal income tax returns.

The S corporation status lets businesses avoid double taxation, which is what happens when the business pays corporate tax and its owners pay taxes on their earnings. In the absence of corporate tax, the S corp "tax rate" is wherever the business owner's personal income level falls on the tax bracket.

Keep in mind that "S corporation" is a tax designation, not a business entity type. You can't as an S corporation. To become one, you have to apply to the IRS.

S corps report their income to the IRS on Form 1120S.

S corporation vs limited liability company

S corporations and limited liability companies (LLCs) are similar business structures. Technically, neither of them pay taxes. Instead, their net taxable income is taxed to the company's shareholders on their personal tax returns.

The differences between S corps and LLCs include:

  • LLCs can have an unlimited number of members: an LLC can be a single-member LLC or a multi-member LLC with unlimited shareholders, but an S corp is capped at 100 shareholders.
  • LLCs can have nonresident alien shareholders: S corps are not permitted to have any non-US citizens as shareholders.
  • LLCs can be owned by corporations, partnerships, trusts, or other LLCs

Further reading: S Corp vs. LLC: What's the Difference?

If you're considering incorporating, talk with an advisor to find out whether an S corporation or LLC is the right business structure for you.

Requirements for becoming an S corp

Step 1: become a C corp (or an LLC)

In order to elect S corporation status your business must first be structured as a C corporation. A C corporation is simply a regular corporation.

Unlike S corporation status, incorporating as a C corporation is something you have to handle through your state. To do this, you file articles of incorporation with your Secretary of State. For more on C corporations and what you'll need to become one, check out our C corporation guide.

Alternatively, you can elect S corp tax filing status if you're a Limited Liability Company and you meet the IRS' criteria for S corp status.

Step 2: make sure you qualify for S corporation status

Not all C corporations can become S corporations, they must meet certain eligibility requirements under the Internal Revenue Code. In order to apply for S corporation status, your company must satisfy the following requirements:

  1. It must be a domestic corporation—that is, based and operating in the United States.
  2. It can only have "allowable" shareholders—this means none of your shareholders can be partnerships, other corporations, or non-U.S. citizens.
  3. It cannot have more than 100 shareholders total.
  4. It can only have one class of stock—for example, it can't have a two-tiered common and preferred stock system.
  5. It can't be an insurance company, bank or a domestic international sales corporation.
  6. All of the company's shareholders must unanimously consent to S corporation status.

Step 3: file IRS Form 2553

Once you've made sure that your company satisfies all of the IRS's requirements, you must then file Form 2553, Election by a Small Business Corporation, signed by all of your company's shareholders. We simplify the S corporation election process with our guide on how to fill out form 2553.

What are the advantages of becoming an S corporation?

Save on taxes

The main tax benefit of becoming an S corp is avoiding double taxation. Some business owners don't like the idea of paying a corporation tax, then paying tax again on their individual tax returns. But to determine whether S corp status is in the best interest of you and your business, you'll need to check with a tax expert.

S corporations aren't taxpayers, and instead only pay employment tax (Social Security and Medicare) on employee wages. All business income is paid to shareholders in the form of "distributions" that are not subject to self-employment tax. This makes the S corporation status very attractive to many small businesses.

The only catch here is that if you're a shareholder and an employee of the company—which many small business shareholders are—you must pay yourself a "reasonable salary" before paying yourself a tax-free distribution.

What exactly is a reasonable salary? The IRS has no hard and fast rules for this one. But you should try to base it on position, experience, business size and what a comparable position at another company in your industry would earn.

S corporation shareholder employees will often try to minimize their salary in order to maximize the size of their tax-free distribution. Whatever salary you decide on, be sure you're able to justify it to the IRS if you ever get audited.

Further reading: S Corp Taxes (A Simple Guide)

Reduced tax payment if you sell

If you ever decide to sell your business, you'll pay a lot less in taxes when selling an S corporation than selling a C corporation.

What are the disadvantages of becoming an S corporation?

Strict requirements

If your company fails to meet any of the IRS's filing requirements for S corporation status at any point, the IRS can revoke it immediately and tax it as a C corporation instead, which could create huge problems around tax time.

If you expect your company might violate one of the IRS's filing requirements—for example, if your fast-growing company plans to expand its shareholder base beyond the 100 allowed shareholders in the near future—S corporation status might not be for you.

Closer tax scrutiny

The IRS keeps a close eye on whether the "reasonable" salaries corporate officers are paying themselves are, indeed, reasonable.

If the IRS suspects a shareholder has misreported wages in order to decrease their tax burden, they may reclassify additional corporate earnings as wages, which could increase the shareholder's tax payment significantly.

Earlier tax filing due date

Pass-through entities (S corporations and partnerships) have an earlier tax filing deadline. The due date for their tax return is March 15 as opposed to April 15 for sole proprietorships, C corporations, and LLCs. Note that these dates move to the next business day if they fall on a weekend or holiday. See our guide on S corp tax deadlines for more information.

Are S corporations taxed equally across states?

While tax advantages make the S corporation an attractive status, S corps are treated differently by each states' tax laws. For instance, some states treat S corps like C corps for state tax purposes, meaning you'll only reap the benefits at a federal level. A tax professional can help you make sure you're aware of your state's S corporation rules.

Further reading

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