An S corp is an organization that has chosen to pass its tax burden to its shareholders, rather than report income, losses, deductions and credits directly to the Internal Revenue Service (IRS). Instead of reporting corporate profits, profits are paid out to shareholders, who include that information in their own tax filings.
Not every corporation is eligible for S corp status. Companies wishing to file as an S corp must meet the following requirements:
- Have 100 or fewer shareholders.
- Have only allowable shareholders (either an individual person or, in some cases, a tax-exempt organization, trust or estate).
- Be a U.S.-based business with no nonresident shareholders.
- Issue only one class of stock.
Additionally, the IRS states that “certain financial institutions, insurance companies and domestic international sales corporations” are ineligible for S corp status. If your business falls under one of these designations, talk to a tax professional to determine your eligibility.
Advantages of an S corp
Asset protection
An S corp structure protects its shareholders’ personal assets. This means that, barring a personal guarantee by a shareholder, if the corporation incurs debt, the members’ homes, bank accounts and vehicles cannot be confiscated to pay the debt.
Employment tax savings
In 2023, all corporations in the United States are required to pay a flat tax of 21% of their taxable income. The money paid out to the shareholders as income is then also taxed according to individual tax rates.
However, an S corp structure allows the corporation to disperse some of those earnings to shareholders as dividends or distributions, not income. While shareholders must receive a reasonable wage, dispersions on top of their wage aren’t taxed as income as long as they do not exceed the shareholders’ initial investments. Some are not taxed at all.
Tax deductions
Shareholders can claim some S corp losses on their personal income taxes to offset their personal income and reduce their tax bill. However, shareholders can’t claim any losses in excess of their stock basis. Determining whether they can claim a loss or not is a complicated endeavor and one that should be left to a tax professional.
No self-employment taxes
Electing an S corp structure also helps a business’s shareholders avoid self-employment taxes. When a member of an LLC receives compensation, they must pay the full share of both Medicare and Medicaid self-employment taxes on their personal income tax returns. However, because shareholders in an S corp are considered employees, they must only pay half of these taxes on wages earned as employment tax.
Shareholder flexibility
Compared to other organizational structures, transfer of ownership is relatively easy with an S corp. Unlike in a limited liability company (LLC) structure, the S corp is its own entity and shareholders can come and go without disrupting the essential structure of the business or its operational continuity.
Disadvantages of an S corp
Operational restrictions
The strict requirements for S corps can limit your flexibility to grow and operate your business as you wish. For example, your S corp can never have more than 100 shareholders. In addition, your shareholders are limited to one class of stock. You must also follow a calendar year tax schedule. Finally, distributions to shareholders (separate from wages) must not exceed their actual investment in the company.
Additional fees
Some states charge a franchise tax or other taxes for any corporations that reside or operate within state lines. S corps in North Carolina, for example, must pay $200 if they have a tax base of $1 million and an additional $1.50 for each $1,000 earned above that. California requires S corps to pay an annual tax of 1.5% or $800, whichever is greater.
Closer IRS scrutiny
Because S corps must follow strict guidelines, they are subject to deeper scrutiny by the IRS to ensure requirements are met. For example, the IRS looks closely at the delineation between wages and distributions, meaning S corps must be careful to give each shareholder who provides a service to the company a “reasonable wage.” Distributions and dividends can’t take the place of wages. Fringe benefits are also taxed as shareholder income.
What is an S corp best for?
An S corp election benefits business members who want the liability protection of a corporation without paying corporate taxes and can meet the requirements without putting undue strain on operations. Family-owned businesses are well-suited to be S corps, as the IRS counts spouses as a single shareholder and the company will likely not need shareholders that don’t meet the requirements (such as other corporations or partnerships).
How to form an S corp
There are several steps you must follow to legally form an S corp. They include the following:
- Ensure your company meets eligibility requirements: Companies with more than 100 shareholders, the wrong type of shareholder or more than one class of stock are ineligible for S corp status. Certain industries are also ineligible, so speak to a tax or legal professional to make sure you qualify.
- Reserve your business name: Corporations are required to register their businesses with their state using an approved name. Business names generally have to be dissimilar enough from existing corporations’ names within the state to avoid confusion and correctly advertise offered products or services.
- Designate a registered agent: Every corporation needs to choose either an individual or organization to serve as its registered agent. This person must be available during all regular business hours throughout the year to receive legal notices and other documents on the S corp’s behalf.
- File articles of incorporation: This is the formal act of registering your corporation with your state, and it comes with a filing fee. The fee amount varies by state, as do the requirements for filling out the form.
- Draft corporate bylaws: Not every state requires formal bylaws to be in place before you incorporate. However, it’s generally a good idea to outline your business processes in advance to protect your company from liabilities, penalties and legal entanglements.
- Establish your board of directors and hold a meeting: Both S corps and C corps must have a board of directors in place before they can operate. Board members are elected by the S corp’s shareholders and must meet annually. During the first meeting, it’s common to ratify the bylaws and elect corporate officers. In all meetings, meeting minutes must be kept.
- Apply for an employer identification number (EIN): An EIN is issued by the IRS and identifies your business before the IRS for tax administration purposes. You can get one for free using the EIN application on the IRS website. The person who applies for the EIN is known as the “responsible party” and should be someone who has direct oversight of company operations and management.
- Issue stock: You must issue stock to your shareholders based on their contributions. This often entails drawing up a bill of sale or a stock certificate. Remember that you can only have one class of stock and that all profits and losses must be passed on to shareholders based on their stock holdings.
- File IRS Form 2553: Filing Form 2553, Election by a Small Business Corporation, is how you inform the IRS that you wish to be considered an S corp for taxation purposes. The form and its filing instructions can be found on the IRS website.
- Identify a wage structure: Some S corps in the past have tried to reduce their tax burden by claiming all income to shareholders as distributions instead of wages. Because of this, the IRS requires all S corps to provide “reasonable compensation for services rendered” to each shareholder. If the IRS isn’t satisfied with the stated compensation, it can reclassify non-wage distributions as wages and tax them as such.
For a more detailed look at how to start an S corp, read our step-by-step S corp formation guide.
S corp vs. C corp: What’s the difference?
In many ways, S corps and C corps provide similar functions. They both establish protections for members’ personal assets and are beholden to shareholders who have a financial stake in the company. However, both designations have benefits and drawbacks depending on the needs and structure of the corporation.
Is an S corp right for your business?
An S corp is not necessarily a better choice than a C corp, LLC, sole proprietorship, partnership or other tax election. Each business type has its own advantages, and you should carefully weigh the pros and cons of electing S corp status to decide if this is the right option for you.
For a small business looking to grow, incorporating as an S corp gives you the protections and credibility of a corporation while letting you retain more of your profits. It also allows you to formalize your business practices without being subject to the more stringent taxes and fees of C corps. Finally, it affords you flexibility an LLC does not, such as the ability to raise funds by issuing stock and change membership as needed without disrupting operations.
Alternatives to an S corp
If an S corp doesn’t sound right for you, there are several other options. Any of these could be a better choice depending on how you operate and structure your business:
- C corp: A C corp is treated as a separate, taxable entity by the IRS but is not restricted in number or type of shareholders or stock classes.
- LLC: A limited liability company is one that can be treated as a partnership, corporation or a sole proprietorship by the IRS. There is no limit to the number of owners an LLC can have, and many states allow LLCs to have single owners. As a pass-through entity, only members pay taxes on profits so the entity avoids the double taxation of a corporation.
- Sole proprietorship: In a sole proprietorship, the owner and the company are essentially a single entity. Sole proprietorships don’t sell stock, don’t pay corporate taxes and don’t protect the owner’s personal assets. However, they require no fees or document filing to set up or operate.
- Partnership: A partnership allows two or more individuals to co-own a business. Like in an LLC structure, one or all members can enjoy limited liability protection on personal assets.
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Frequently asked questions (FAQs)
Like an S corp, an LLC provides legal protections to its owners, so personal assets cannot be seized to pay business debts. However, LLCs don’t have the same shareholder and owner restrictions as S corps. Some states require LLCs to dissolve if their membership changes and LLC owners are often subject to self-employment taxes.
Unlike an LLC, an S corp can exist in perpetuity and its members take a wage instead of being self-employed. They can also issue stock to raise funds for business growth. Profits on top of wages are distributed to shareholders and taxed at a lower tax rate than corporate or self-employment tax.
If your company meets all S corp requirements and you want to stop paying federal corporate taxes, you can file form 2553 and elect S corp status. As an S corp, you will avoid double taxation, but individual shareholders might be taxed at a rate higher than most corporations. Before making the switch, evaluate your company finances and membership to determine if the pass-through system will result in better profit margins for your shareholders and if your business qualifies for an S corp election.
Businesses are eligible to elect S corp status if they meet the IRS requirements, including:
- The business has a maximum of 100 shareholders.
- It only issues one class of stock.
- Its shareholders are all individuals or certain trusts/estates.
- The company and all shareholders reside in the US.
If your company is eligible for S corp status based on these requirements, talk to a tax or legal professional about next steps.
