An S corporation (S corp) is a type of corporation designed to avoid the double taxation that regular corporations or C corporations (C corps) pay. Tax authorities typically treat an incorporated business as a C corp and tax it at both the corporate level on income and at the shareholder level on dividends. But an S corp passes corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes.

According to a 2021 report from the US Bureau of Economic Analysis, S corps account for nearly 77% of corporations with fewer than 500 employees and about 37% of corporations with more than 500 employees. Below, we’ll explain how S corps work, how they compare to other business structures, their benefits and disadvantages, and how to create one.

What’s in this article?

• How does an S corp work?
  
• S corps vs. LLCs
  
• S corps vs. C corps
  
• Benefits of being an S corp
  
• Disadvantages of being an S corp
  
• IRS requirements for an S corp
  
• How to create an S corp
  

How does an S corp work?

Here’s how to form an S corp and how it functions.

Formation and election

A business legally registers with the state as a corporation. The corporation then elects S corp status by filing Form 2553, “Election by a Small Business Corporation,” with the IRS, assuming it meets the eligibility requirements.

Ownership and management

Shareholders own S corps through the shares they hold. They elect a board of directors that oversees the company’s operations. The board of directors appoints officers who manage the company’s day-to-day operations.

Profit distribution

S corps can distribute profits to shareholders through salaries, distributions, or both. The company pays shareholders who are also employees “reasonable” salaries to abide by payroll taxes. Shareholders might pay income tax on distributions.

Pass-through taxation

Avoiding double taxation is a major advantage of S corps. The S corp itself does not pay federal corporate income tax. Instead, its profits and losses pass through to the shareholders’ personal income tax returns. Businesses with losses can benefit from passing through their losses, as shareholders might be able to offset other income on their personal tax returns.

Each shareholder reports their share of the S corp’s income, deductions, and credits on their individual tax return. They then pay for this income at their individual income tax rate.

Limited liability

Shareholders of an S corp have limited liability protection, meaning their personal assets generally receive protection from the company’s debts and liabilities.

S corps vs. LLCs

Both S corps and limited liability companies (LLCs) are popular choices for business owners seeking limited liability protection without the double taxation of the C corp. Both structures have distinct advantages and considerations, making them suitable for different business needs and situations. Here are the key differences between S corps and LLCs.

S corps

• Formation and maintenance: S corps must file articles of incorporation with the state, adopt company bylaws, issue stock, and hold regular board and shareholder meetings. They must also file Form 2553 with the IRS to elect S corp status.

• Ownership restrictions: S corps cannot have more than 100 shareholders, and the shareholders must be US citizens or residents. C corps, other S corps, LLCs, partnerships, and many trusts cannot own S corps.

• Tax treatment: S corps automatically pass corporate income, losses, deductions, and credits to shareholders. Shareholders report these amounts on their personal tax returns and pay taxes at their individual rates. S corps avoid the double taxation of C corps, but they must adhere to strict IRS rules.

• Compliance: Due to their corporate nature, S corps have stricter reporting and compliance requirements. They must adhere to formalities to preserve the corporate veil and avoid issues with the IRS.

• Management: S corps typically feature a structured corporate management framework, including a board of directors and officers. This structure is more rigid, but it clarifies roles and responsibilities.

• Profit distribution: S corps must distribute profits according to each owner’s proportion of stock. This can limit the flexibility of profit sharing.

LLCs

• Formation and maintenance: It’s generally simpler to form and maintain LLCs. LLCs must file articles of organisation with the state and often create an operating agreement. They have fewer ongoing formalities compared to S corps and don’t require annual meetings or formal minutes.

• Ownership restrictions: LLCs have no restrictions on the number or type of owners (referred to as members). Individuals, corporations, other LLCs, foreign entities, and trusts can own LLCs.

• Tax treatment: In taxation, LLCs are flexible. By default, tax authorities treat them as pass-through entities, similar to S corps. But LLCs can also choose to be taxed as a C corp or an S corp, if they meet the requirements.

• Compliance: LLCs typically face fewer compliance and procedural requirements, making it easier for smaller or less formal businesses to operate without the burden of substantial corporate formalities.

• Management: Members can manage the LLC themselves or appoint managers, who can be members or outsiders. This flexibility can benefit owners who prefer a less formal structure or need to adapt their management approaches.

• Profit distribution: LLCs can distribute profits in almost any manner agreed upon by the members, regardless of ownership percentages. This provides flexibility, especially for investors or partners contributing different amounts of time, effort, or resources.

S corps vs. C corps

Here are the similarities and differences between S corps and C corps.

Formation and regulatory requirements

Both S corps and C corps must file articles of incorporation with the state, adopt bylaws, issue stock, and hold regular board and shareholder meetings. Corporate laws require both to follow formalities such as annual reports and formal record-keeping.

Tax treatment

C corps pay corporate income tax on profits, and then shareholders pay dividend taxes.

S corps pass corporate income, losses, deductions, and credits through to shareholders, who report these amounts on their personal tax returns. S corps avoid double taxation on corporate income because only shareholders pay taxes.

Ownership restrictions

C corps have no restrictions on ownership. They can have an unlimited number of shareholders, and there are no restrictions on who can be a shareholder (e.g., individuals, corporations, and non-US citizens or residents).

S corps cannot have more than 100 shareholders, and shareholders must be US citizens or residents. C corps, other S corps, LLCs, partnerships, and many trusts cannot own S corps. Shareholders also cannot own more than one class of stock, though they can have different voting rights.

Stock and investment flexibility

C corps can issue multiple classes of stock with different rights, preferences, and values. This can be attractive to venture capitalists and investors looking for preferred shares.

S corps can issue only one class of stock, though they permit differences in voting rights. This can limit investment, as there is less flexibility in structuring ownership and control.

International tax issues

C corps have a more favourable structure for international businesses, since they allow those who are not US citizens or residents to own shares and allow investments from other foreign entities.

S corps must only give shares to those who are US citizens or residents, which might limit international investment opportunities.

Management and corporate structure

S corps and C corps both have boards of directors who oversee the corporation and officers who manage day-to-day operations. This creates a clear division between ownership and management, which can benefit larger organisations.

Ideal use cases

C corps are best suited for larger, growth-oriented businesses that plan to go public or seek major outside investment since they can issue different classes of stock and have no shareholder limitations.

S corps are more suited for small and medium-sized businesses that will remain privately owned and want to avoid double taxation. Businesses expecting to distribute profits regularly to shareholders can benefit from pass-through taxation.

Benefits of being an S corp

Incorporating as an S corp can create the following benefits for your business:

• Avoiding double taxation: While C corps pay double taxation, S corps pay taxes only once. This is their biggest benefit.

• Passing through losses: If your business experiences losses, it can pass them through to shareholders and potentially offset other income on shareholders’ personal tax returns. This reduces their overall tax burden.

• Lowering self-employment taxes: Shareholders who are also employees of the S corp must receive reasonable salaries, subject to payroll taxes. Shareholders don’t pay self-employment tax (i.e., Social Security and Medicare) on additional, distributed profits, which can result in major savings.

• Maintaining limited liability protection: S corp shareholders enjoy limited liability protection, meaning the company’s debts and liabilities don’t affect their personal assets (e.g., homes, cars, personal savings). This protection extends to lawsuits, bankruptcies, or other financial troubles the business might encounter.

• Increasing credibility and professionalism: Incorporating as an S corp can lend credibility and professionalism to your business in the eyes of customers, suppliers, and investors. Obtaining financing and attracting talented employees might become easier as a result.

• Providing more investment opportunities: Some investors prefer to invest in S corps due to their pass-through tax structure and potentially lower tax liabilities. This can make it easier to raise capital for your business.

• Establishing perpetual existence: Unlike sole proprietorships or partnerships, an S corp can continue existing even if ownership changes or a shareholder dies. This provides stability and continuity for your business.

• Enabling easier ownership transfer: S corp owners can easily sell or gift their shares, which can make ownership transfer smoother and create estate planning benefits.

• Allowing for deductions: S corps can deduct certain business expenses such as health insurance premiums for employees (including the owner), which can lower the company’s taxable income.

Disadvantages of being an S corp

While S corp status offers many advantages, it also presents the following challenges:

• Shareholder limitations: S corps cannot have more than 100 shareholders, and the shareholders must all be US citizens or residents. This can restrict S corps’ ability to raise capital from a broader investor base.

• One class of stock: S corps can only issue one class of stock, meaning all shareholders have the same rights and privileges. This can be a disadvantage when your company seeks to attract different types of investors or incentivise employees with different types of stock options.

• Higher personal taxes: If your S corp is highly profitable, shareholders might pay more in personal income taxes than they would in a C corp. S corps pass their profits through to shareholders, who pay for them at their individual income tax rates. These can be higher than C corps’ corporate tax rate.

• Increased IRS scrutiny: S corps can receive more IRS scrutiny than other business structures due to their unique tax advantages. S corps need to keep detailed records and ensure compliance with all regulations to avoid audits and penalties.

• Reasonable salary requirements: If you are a shareholder and an employee of your S corp, you must receive a “reasonable” salary that is subject to payroll taxes. Determining a reasonable salary can be complicated and requires careful consideration to avoid IRS scrutiny.

• Administrative complexity: S corps require more formalities and paperwork than other business structures such as sole proprietorships or partnerships. These include filing articles of incorporation, electing S corp status with the IRS, holding regular shareholder and board meetings, and keeping detailed corporate records.

• Limited flexibility in allocating profits and losses: S corps must allocate profits and losses to shareholders based on their percentages of ownership. This can be a drawback if you want to allocate profits or losses based on other factors such as shareholders’ contributions.

IRS requirements for an S corp

Here are the key IRS requirements for an S corp:

• The corporation must be a domestic corporation, meaning it is incorporated under the laws of a US state or territory.

• There must be 100 or fewer shareholders. For the purposes of this count, family members can be treated as a single shareholder under specific circumstances.

• The shareholders must be individuals, certain trusts, or estates. Partnerships, corporations, and those who are not US citizens or residents cannot be S corp shareholders.

• The corporation can have only one class of stock, though differences in voting rights among shares are permitted. This means the corporation cannot issue preferred stock that offers different distributions or liquidation rights.

• Certain types of corporations cannot elect to be S corporations, including certain financial institutions, insurance companies, and international sales corporations.

• The corporation must elect to be an S corporation by filing IRS Form 2553.

  • The corporation must file the form no more than 2 months and 15 days into the tax year the election is to take effect, or it can do so at any time during the preceding year. If the company files the form late, S corp status might not take effect until the next tax year, unless the IRS grants relief for a late election under certain circumstances.
    
  • All shareholders must agree to the election and sign the form.
    

How to create an S corp

If your business meets the requirements to be an S corp, you can follow these steps to incorporate and start operations.

Form a corporation

• Select a unique business name that complies with your state’s naming rules and is not already in use.

• Prepare and file the articles of incorporation with your state’s business filing agency. These documents outline the company’s basic information, purpose, and structure.

• Create bylaws that explain the company’s operating rules, shareholder rights, and procedures for meetings and decision-making.

• Appoint directors and officers (e.g., president, secretary, treasurer) to manage the company’s affairs.

• Issue shares of stock to the company’s shareholders according to their ownership percentages.

Elect S corp status

• Complete and file Form 2553 with the IRS.
  

Obtain an Employer Identification Number (EIN)

• Apply for an EIN through the IRS website. Even if you already have an EIN for your business, you might need to get a new one for your S corp.
  

Comply with ongoing requirements

• S corps must hold annual shareholder and board meetings to follow corporate formalities.

• Keep detailed corporate records of all business transactions, meeting minutes, and shareholder information.

• File an annual income tax return (Form 1120-S) and submit Schedule K-1s for each shareholder, reporting their share of the company’s income, deductions, and credits.