When choosing a business structure, taxation is a major consideration. Each enterprise must examine its needs and determine which structure best suits its purposes. Several structures help businesses avoid liability, so entrepreneurs can focus on other aspects when evaluating their choices. For small business owners, an S corp may prove worthwhile if they meet the eligibility criteria and benefit from its tax treatment.
An S corporation is not the type of company that is formed at the state level. It is a corporation that has elected a specific tax treatment from the IRS. Learn more about when an S corp makes sense because of its tax structure, comparison with other business entities, and requirements.
What is an S corporation in simple terms?
As a basic definition, an S corporation is a corporation that elects to be taxed under Subchapter S of the Internal Revenue Code. It allows income, losses, deductions, and credits to pass through to shareholders. The corporation generally does not pay federal income tax at the entity level. Shareholders report income on their personal tax returns.
While state corporate law treats S and C corps in the same way structurally, the tax treatment is different. S corp shareholders receive pass-through income, which they report on their personal income taxes. They can also pass through certain business losses on their personal taxes. C corps pay corporate tax on profits. Dividends received by shareholders are taxed on the personal level.
The corporation is formed first. After formation, the business files IRS Form 2553 to elect S corp status.
How is an S corporation taxed?
Understanding how an S corp is taxed is crucial to your decision-making. One key element is that shareholder-employees must receive a “reasonable salary.” That means the approximate salary they would receive in a comparable position. The IRS is not going to accept a shareholder-employee paid $1 a year.
S corporation employees are those corporate officers or shareholders performing a service for the corporation who receive or are entitled to payments, as those payments are considered wages. Courts have held consistently that S corp officers and shareholders providing more than “minor” services to the corporation and receiving compensation must pay federal employment tax.
S corps feature pass-through taxation. All the company’s income, deductions, credits, and losses pass through the shareholders’ personal income tax returns. Shareholders pay income tax at their individual rates. The S corp itself does not pay corporate federal income taxes. It avoids double taxation as a corporate entity as well as at the individual level.
They must file Form 1120-S, Shareholder’s Share of Income, Deductions, Credits, etc., also known as Schedule K-1, annually. S corp shareholders are issued Schedule K-1s. Schedule K-1 for partnerships requires the filing of Form 1065.
While salaries are subject to payroll taxes, remaining profits may be distributed and are not subject to self-employment tax. The potential tax advantage comes from splitting salary and distributions.
Reasonable compensation for S corps
Keep in mind that the IRS monitors reasonable compensation. If an S corp officer or shareholder appears to have an unreasonably low salary, the IRS may reclassify distributions as wages. The individual is then faced with potential back taxes, along with interest and other penalties. Payroll tax audits are among the IRS’s favored methods of ensuring the S corp is not trying to avoid paying such taxes.
S corp vs C corp
Consider the following when deciding whether S corp or C corp status is the better option for your business:
| Category | S Corporation (S Corp) | C Corporation (C Corp) |
|---|---|---|
| Taxation | Pass-through taxation (profits taxed once at the shareholder level) | Double taxation (taxed at corporate level + dividends taxed to shareholders) |
| Ownership Limits | Maximum of 100 shareholders; some family members may count as one | Unlimited number of shareholders |
| Stock Structure | Only one class of stock allowed | Multiple classes of stock allowed (e.g., common, preferred, voting, non-voting) |
| Shareholder Eligibility | Only U.S. citizens or permanent residents; certain trusts and estates allowed; no nonresident aliens | Open to U.S. and foreign investors, including individuals and entities |
| Investor Appeal | Less attractive to institutional investors and venture capital | Preferred by venture capitalists and scalable startups |
| Typical Use Case | Small, closely held businesses seeking tax simplicity | High-growth companies planning to scale or raise funding |
S corp vs LLC
Many small businesses opt for a Limited Liability Company (LLC) structure. Some LLC owners may find that an S corp is another alternative due to its attractive tax structure. Both structures offer liability protection.
LLC regulations vary by state statute. However, the IRS does not permit banks or insurance companies to operate as LLCs. A bank can operate as an S corp, and that is a common business structure. An insurance company cannot operate as an S corp, and usually has C corp status.
When forming an LLC, its members are considered self-employed. While their profits and losses are passed to their personal income, they avoid corporate taxation. As self-employed individuals, they must pay self-employment tax contributions to Social Security and Medicare. That tax rate is 15.3 percent. When a person works for an employer, the employer pays half of the Social Security and Medicare contributions.
Since S corp shareholder/employees are on the payroll, they pay Social Security and Medicare taxes at that lower rate.
Here’s a closer look at an S corp vs LLC:
| Category | Limited Liability Company (LLC) | S Corporation (S Corp) |
|---|---|---|
| Legal Structure | A legal business entity formed under state law | Not a legal entity; a tax election applied to a corporation or eligible LLC |
| Tax Flexibility | Highly flexible (can choose default taxation or elect S corp status) | Must follow IRS Subchapter S rules; limited flexibility once elected |
| Ownership Rules | No limit on members; foreign owners allowed | Limited to 100 shareholders; no nonresident alien shareholders allowed |
| Administrative Requirements | Simpler administration; fewer compliance requirements | More complex (requires payroll for shareholder-employees and stricter compliance) |
| Tax Strategy Potential | Can remain simple or elect S corp status for potential tax savings | Often chosen specifically for potential payroll/self-employment tax advantages |
| Typical Use Case | Flexible structure for small businesses, freelancers, and startups | Businesses with consistent profit looking to optimize taxes |
S corp requirements
Eligibility for the S corp designation includes:
- Must be a domestic corporation.
- Must have 100 or fewer shareholders.
- Shareholders must be eligible, such as individuals, certain trusts, and estates.
- No nonresident alien shareholders.
- Only one class of stock permitted.
All shareholders must consent to the election. For instance, if you have 50 shareholders, but two do not want to change the corporation to an S status, the election cannot move forward.
Any violation of these rules can terminate S corp status. IRS approval is required for election.
S corporation advantages and disadvantages
There are pros and cons to any type of business structure. Some businesses are a good fit for one type but less so for another.
Advantages of an S corp
Besides limited liability protection, the major advantage of an S corp is its single level of federal taxation. While the IRS taxes corporate profits, it also levies taxes on dividends paid to shareholders. That is a double level of taxation.
The potential payroll tax savings from not paying self-employment tax, as with an LLC, are significant.
In addition to passing on profits, an S corp also passes through any losses. Unlike C corp shareholders, S corp shareholders can write off some company losses on their personal income taxes.
Disadvantages of an S corp
Besides the IRS’s strict eligibility requirements, other downsides of an S corp include:
- Ongoing payroll obligations: An S corp requires that shareholder/employees receive reasonable salaries. Such payroll obligations include income tax withholding, paying Medicare, Social Security, and federal unemployment tax, and depositing and reporting employment taxes.
- One class of stock restriction: An S corp cannot offer preferred stock.
- Shareholder limitations: Membership is limited to 100, and they must be domestic entities or residents. That also means your business cannot expand internationally and add non-U.S. citizens or permanent residents as shareholders.
Keep in mind the administrative burden for S corps is greater than that of sole proprietorships or partnerships. While it can achieve tax savings, make sure these savings can justify the compliance costs.
How to form an S corporation
Step 1: Form a corporation with the state
Start the S corp formation process by:
- Appointing a registered agent
- Adopting bylaws.
- Issuing stock.
Step 2: Obtain an EIN
Obtain an Employee Identification Number (EIN) from the IRS. You must form your legal entity and register it with your state before filing an EIN application.
Step 3: File Form 2553 with the IRS
Businesses must file Form 2553 with the IRS, Election by a Small Business Corporation. Only domestic corporations can file. Every shareholder must sign this form for S corp eligibility.
The filing has strict deadlines. It must be filed no more than two months and 15 days after the beginning of the tax year for the election to take effect, or at any time during the tax year preceding the tax year it is to take effect. For instance, if your small business’s tax year starts on January 1, you must file Form 2553 by March 15 for eligibility that year. Miss that deadline, and your business will not receive this effective tax treatment until the following tax year.
S corp status is not automatic. It must meet all IRS tests.
Maintaining S corp status
Once you have formed an S corp, there are ongoing compliance responsibilities. Maintaining S corp status requires:
- Filing annual corporate reports with the state.
- Maintaining a registered agent: This is an individual or business that can accept service of process or other legal documents and compliance notices.
- Observing corporate formalities.
- Running a payroll properly.
- Filing Form 1120-S annually.
Take care not to inadvertently jeopardize your S corp status. Your business could lose its S corp status should you add ineligible shareholders, such as those who are not U.S. citizens or green card holders. S corp status is also revoked if a second class of stock is issued. Should revocation occur, the business is taxed as a C corp.
When does S corp status make sense?
S corps make sense for profitable owner-operated businesses or companies with consistent earnings. Payroll tax efficiency is another critical component of an S corp. For a closely held company not seeking venture capital, the S corp may make a good choice. S corp status does not make sense for businesses planning to branch out internationally.
In comparison, business structures such as a sole proprietorship offer no liability protection. If you are sued by a customer, your personal assets are at risk. That may include your house and bank accounts. An LLC and an S corp both offer liability protection, which translates into peace of mind.
If S corp status, with its payroll and other administrative requirements, is more than your business wants to take on, an LLC with its default taxation and simpler administration is a better fit.
If raising outside capital for your company is a primary focus, a C corp makes more sense than an S corp.
Conclusion
For certain small, closely held businesses, an S corp is often a suitable choice. Remember that an S corp is a tax election, not a separate entity type. While an S corp offers pass-through taxation and potential payroll tax advantages, it also comes with strict requirements and administrative responsibilities. These include only permitting domestic entities and shareholders.