What is an S Corp?
Seeing your small business start to succeed and grow into a well-established company is a
dream come true for entrepreneurs. But as your company grows, your tax rate tends to
grow too. Growing companies face a variety of complexities during tax season, and that’s
why when your company starts growing, you may want to consider forming an S Corporation,
otherwise known an S Corp. The S Corp is a business entity that offers significant tax
advantages while still preserving your ownership flexibility.
An S Corp, also known as the subchapter or small business corporation, is a tax code that
was enacted into law by Congress in 1958. The S Corp was created to encourage and
support the creation of small and family businesses, while eliminating the double
taxation that conventional corporations were subjected to.
How Is an S Corp Different from a C Corp or an LLC?
Unlike traditional C Corporations, also called C
Corps, the S Corporation is not subject to corporate income taxes. Instead, the
S Corporation receives different treatment for tax purposes that is generally more
favorable to the business owner. The S Corp is a pass-through entity for tax purposes,
similar to the LLC. This means that the income
generated by an S Corporation will flow through to the personal income tax returns of
the shareholders, and the S Corp itself generally does not owe any tax liability.
Structuring your business as an S Corp also gives you certain flexibility for managing
the ownership of the company. The stock of S Corporations is freely transferable, while
the interest (ownership) of LLCs is not. This means that the shareholders of S
Corporations can sell their ownership interest without obtaining the approval of the
Another area of concern for business owners is reducing their liability for
self-employment taxes, and an S Corporation can have an advantage over an LLC in this
area as well. To visualize how much an S Corporation can save you in taxes, check out
Corporation Tax Calculator.
The compensation (salary and bonuses) of S Corporation shareholders is subject to
self-employment tax, but not the profits automatically allocated to them as a
shareholder. Depending on how you pay yourself throughout the year, and depending on how
your income appears on your personal tax return, you can effectively minimize your tax
burden by reducing the amount of your business profits that are subject to
self-employment taxes. Talk to your accountant or professional tax advisor about the
best way to structure your business
earnings for tax purposes.
Although the S Corporation offers significant tax advantages and ownership flexibility,
it is not the right choice for every business. There are a few restrictions as well.
An S Corporation must adhere to the following limitations:
- It may not have more than 100 shareholders.
- It is required to be a domestic business entity.
- The shareholders of the S Corporation must be US Citizens or legal residents of the United States.
- The S Corporation is restricted to only one class of stock.
Depending on your long-term business goals – for example, if you want your company to be
publicly traded, or if you want to have international shareholders, a C Corporation
might be a better choice of business entity, because C Corporations have no limitations
on ownership and can offer multiple classes of stock. But if you are a U.S.-based
business and are satisfied to work and grow within these limitations, the S Corporation can save you a
lot of money and avoid a lot of hassles as your company expands.
How to Qualify for S Corporation Status
According to the IRS, to qualify for S Corporation
status, a business must meet these requirements:
- Be a domestic corporation
- Have only allowable shareholders – which may include individuals, certain trusts,
and estates, but not partnerships, corporations or nonresident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance
companies, and domestic international sales corporations)
The corporation must also submit Form 2553 to elect S Corporation status for tax purposes.
Advantages of Forming an S Corp
S Corporations offer several advantages if your company qualifies:
- Tax advantages: S Corporations are exempt from federal income tax
except for certain capital gains and passive income. Similar to the LLC, the S
Corporation allows profit to pass through to its shareholders, and the income is
then taxed on the shareholders’ personal tax returns at each shareholder’s
individual tax rates. Because the S Corporation is a pass-through entity, this
ensures that the corporation’s profits are only taxed once – at the shareholder
level. This means that S Corporations avoid having to pay what is often referred to
as “double taxation” of dividends.
See how much you can save with our S
Corporation Tax Calculator.
- Asset protection: If your business is an S Corporation, you have
certain legal protections for your personal assets which are separate from the
assets of the business. For example, shareholders are not personally liable for the
company’s debts or liabilities, and for the most part, creditors are not able to go
after the shareholders’ personal assets in order to recover business debts.
- Flexible characterization of income: Being an owner of an S
Corporation gives you flexibility in how to characterize your income for tax
purposes. As the owner/shareholder of an S Corp, you can be an employee of the
business and pay yourself a salary. In addition to your salary, you can also pay
yourself dividends from the S Corporation or distributions that are generally
tax-free or taxed at a lower rate than the employee’s salary. This helps you reduce
your self-employment tax liability, as long as you are characterizing your salary
and dividends/distributions in a reasonable way. The IRS does not want to see you
paying yourself an artificially low salary in order to avoid paying self-employment
taxes on the “dividend/distribution” portion of your income.
- Easy transfer of ownership: S Corporation ownership interests are
easy to transfer to other owners without causing significant tax consequences or
terminating the corporate entity. An ownership transfer of an S Corporation does not
require adjustments to property basis or compliance with complicated accounting
Drawbacks of an S Corporation
The S Corporation structure is not right for every business’s situation, and it presents
certain drawbacks and downsides:
- Restrictions on Ownership: S Corporations do not have the same
degree of flexibility in their ownership structure, compared with a C Corporation. S
Corps can only offer one class of stock, which limits the appeal to different types
of investors. Also, the S Corp can only have 100 shareholders (or fewer) and cannot
be owned by foreign shareholders or by certain trusts or other corporate entities.
- Caution about Wages and Dividends: One of the great aspects of the
S Corporation is its flexibility in characterizing income as wages or dividends, but
this can also present challenges. The IRS is always on the lookout for business
owners that are not fairly or accurately characterizing their payments of wages, so
as an S Corporation owner, you have the risk of being asked to re-characterize some
of your income and pay higher taxes as a result.
- Tax Qualification Mistakes: This is a rare scenario, but it does
happen – sometimes, S Corp owners will make mistakes related to their IRS form
filing requirements related to stock ownership, election, consent, notification and
other aspects of running an S Corp, and this can cause the company to lose its S
Would you like to set up your business as an S Corporation, or set up your LLC to file as
an S Corporation? If so, you can choose S Corporation status for tax purposes by filing
IRS Form 2553 within 75 days of the filing date of the company or by filing IRS Form 2553
by March 15 of the tax year the election is to take effect, or any time during the tax
year prior to the tax year it is to take effect.
S Corp vs. C Corporation
What do these two types of corporate structures have in common?
|Limited Liability (shareholders are
not personally responsible for
business debts and liabilities)
|Have shareholders, directors and officers
|Must file annual reports, adopt
bylaws, and conduct other corporate
Separately taxable entity
(must pay corporate income tax)
Pass-through tax entity (business’s
profits/losses are reported on
owners’ personal tax returns)
Has restrictions on ownership
Can have more than 100 shareholders
All shareholders must be U.S. citizens/residents
Can offer multiple classes of stock