What is an S Corporation?
What are the advantages and disadvantages of an S Corp?
How does it work?
In this article, we will break down the notion of “S Corporation” so you know all there is to know about it.
We will look at the S Corporation definition, what it means, how it works, its benefits and drawbacks, how you can form one, what are the S Corp requirements, taxation, compare it to a C Corp and more.
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Table of Contents
What is an S Corporation
An S Corporation (also known as S Corp or Subchapter S Corporation) is a business entity distinct from its shareholders qualifying for different tax treatment under the Internal Revenue Code.
In essence, an S Corporation will report its business revenues and losses directly in its shareholders’ hands (pass-through taxation) thereby avoiding the double taxation mechanics applicable to a C Corporation.
In other words, S Corporations will not report a separate corporate income tax at the entity level.
Instead, shareholders report the business income and losses on their personal income tax reports.
This type of taxation resembles the taxation structure of partnerships or an LLC rather than corporations.
In essence, an S Corporation is more a tax status or tax designation than a different type of business entity.
Fundamentally, an S Corp is a “corporation” offering its shareholders all the benefits of running a business as a corporation such as limited liability protection.
To qualify as an S Corporation, the IRS requirements are the following:
- The company cannot have more than 100 shareholders
- The company shareholders must all be American citizens
- The company can only issue one class of stock to all the shareholders
S Corporation definition
By definition, an S Corporation refers to the tax status applicable to the corporation and not business entity type.
A corporation formed in the United States and who qualifies under Subchapter S of the Internal Revenue Code will be designated as an S Corporation for tax purposes.
An S Corporation will have:
- No corporate income tax to pay (one taxation lawyer)
- The S Corp shareholders report the business income, profits, losses, deductions and credits on their personal income tax return (pass-through tax entity)
From a legal perspective, the definition of an S Corporation is the same thing as the definition of a Corporation.
According to the Merriam-Webster dictionary, a corporation is defined as:
A body formed and authorized by law to act as a single person although constituted by one or more persons and legally endowed with various rights and duties including the capacity of succession
The Subchapter S Corporation definition is a legal entity formed by filing the required articles of incorporation with the state and making a tax election with the IRS.
An S Corporation (or more generally a “corporation”) can be distinguished from other types of business entities such as:
- Sole proprietorships
- Limited liability companies
S Corporation requirements
When a “corporation” is formed, it is considered a C Corporation for tax purposes by default.
As such, a C Corp will be required to pay taxes on its own revenues and file its own corporate income tax report.
Any profits that are paid to the shareholders will be taxed again in the hands of the shareholders.
This results in double taxation where the same dollar of business revenue is taxed as corporate income in the hands of the corporation and as dividends in the shareholder’s hands.
On the other hand, a corporation can elect to become an S Corporation if it qualifies as such.
The most notable benefit of qualifying as an S Corp is to avoid double taxation.
Being taxed under Subchapter S, S Corps will pay taxes similar to partnerships where business income is passed down to the shareholders and taxed only once in their hands.
To qualify as an S Corp, here are the requirements:
- The corporation must have 100 shareholders or less
- The corporation’s shareholders must be U.S. citizens
- There can only be one class of S Corporation stock
From the perspective of an S Corporation ownership rules, there are some restrictions.
Typically, the shareholders must be individual U.S. citizens.
Partnerships, estates and trusts (except for some), tax-exempt corporations and other corporations do not qualify as eligible shareholders under Subchapter S.
Forming an S Corporation
S Corporations are formed or organized by following the incorporation steps with the applicable state.
Let’s see how it works in a nutshell before we describe it in more detail:
Let’s look at these steps in further detail.
Typically, the first step in forming an S Corporation is to choose your business name.
It’s important that the name you intend to give to your S Corporation be available.
A corporation must have the abbreviation “INC” in its name.
Check out our article on the meaning of INC to learn more about that.
To verify that, you can perform a business entity name search or reserve the business name by following the local state requirements.
Once you have decided on your name, the second step is to draft and file your articles of incorporation with the Secretary of State or equivalent agency.
Every state will have its unique forms and procedures for filing the articles of incorporation.
You’ll need to ensure you comply with the domestic requirements.
In addition to your incorporation articles, the third step is to file your Form 2553 with the IRS.
You have 75 days to file Form 2553 with the IRS to elect to be taxed under Subchapter S instead of Subchapter C by default.
Once our company is formed, you will receive a certificate of incorporation issued by the state confirming your company’s legal existence.
The fourth step is for the corporation to hold its first organization meeting where the shareholders receive their stock certificate, directors are appointed and company bylaws adopted.
You must then file a Form SS-4 to obtain its Employer Identification Number (also referred to as EIN).
The EIN is the number associated with the S Corporation when dealing with the IRS or the authorities for corporate income tax, payroll, unemployment, disability taxes and others.
If a business license is needed, the S Corporation must apply for the necessary business license (that may be needed per state, county or township).
You have a few options when looking to form your S Corporation:
- Handle everything yourself (cheapest option but may lead to costly errors)
- Hire an incorporation service company (moderate cost, good quality of service but without legal advice)
- Hire a business lawyer or incorporation lawyer (highest cost and suitable for those looking for strategic advice)
S Corporation advantages
So what are the S Corporation pros and cons?
Let’s start with the S Corporation benefits and then we’ll address the drawbacks.
The main advantage in electing an S Corp status is to benefit from the flow-through taxation.
This allows the business owner to save money by not filing and paying federal taxes at the entity level.
S Corps provide a taxation regime suitable for business owners looking to take out much of the business profits and avoid paying an excessive amount of tax.
In addition to the advantage of being a pass-through entity under federal tax laws and in most states, S Corporations provide all the benefits offered by a corporation, such as:
Business owners and entrepreneurs who are running a small business, are not looking to raise capital through the issuance of equity securities and are looking to remain fully owned by American citizens are suitable businesses to operate their business as an “S” corporation.
S Corporation disadvantages
Although pass-through taxation provides for a great incentive for business owners and entrepreneurs to elect S Corp taxation, there are some drawbacks that you should be aware of.
Here are some of the most notable disadvantages or drawbacks in running a business as an S Corp:
Startups, founders, entrepreneurs and business owners looking to raise capital by selling stock to investors, venture capitalists or going public are better select a C Corporation rather than an S Corporation.
S Corp taxes
S Corporations are subject to the Subchapter S of the Internal Revenue Code taxation regime from a tax perspective.
Subchapter S corporations can report business income, losses, deductions and credits directly in the shareholders’ hands.
Only certain types of gains or passive income may be taxed directly in the S Corporation’s hands, but most of its income will be flown down to its shareholders.
Unlike C Corporations, S Corporations do not have to report their taxes separately by filing its own corporate income tax report.
Instead, the shareholders will individually report the business income on their individual income tax report.
Unlike a C Corporation, an S Corporation is not a separate taxable entity.
While C Corporations must file a corporate income tax return using Form 1120 and pay taxes, an S Corporation will not have to pay any federal income taxes but will file an informational income tax return using Form 1120S.
Another advantage of an S Corporation is that it can use the cash method accounting for reporting income instead of the accrual method applicable to C Corporations.
This makes financial reporting and accounting simpler to handle.
What’s also interesting with S Corporations is that business owners can reduce their self-employment tax liability by having the ability to draw salaries as employees and get dividends as shareholders on a tax-free basis to the extent of their investment in the corporation.
If the S Corp makes a reasonable allocation of salary and dividends, it can deduct the salary as a business expense and make wages-paid deductions while at the same time taking advantage of a tax-free dividend payment.
Regarding fringe benefits, most of them are taxable as compensation to the employee-shareholders owning more than two percent of the corporation.
Finally, an S Corporation must adopt the calendar year as its tax year instead of a fiscal year unless it can justify such a decision.
S Corp vs C Corp
Fundamentally, an S Corporation and a C Corporation are the same types of business entities.
They are both “corporations” incorporated by filing the necessary articles of incorporation with the Secretary of State or equivalent state agency and they are governed by the same state laws.
The “S” corporation designation or the “C” corporation designation distinguishes the corporation’s tax regime under the Internal Revenue Code.
Whether a company is an S company or a C company, they are both the same legal entity to start with but taxed differently.
Let’s look at the difference between an S Corporation vs C Corporation from an ownership and taxation perspective.
From a tax perspective, the difference and S Corp and C Corp can be summarized as follows:
From an ownership perspective, we can nuance an S Corp vs C Corp as follows:
S Corporation vs LLC
An S Corporation has many similarities with a limited liability company but also some differences.
Here are the similarities:
- Limited liability protection
- Business credibility
- Pass-through taxation
On the other hand, a limited liability company or LLC can be owned by non-U.S. citizens and non-Americans while only American citizens or resident aliens can hold an S Corporation.
As such, an LLC can be a pass-through entity for tax purposes but not have the same restrictions as an S Corporation such as having no more than 100 owners, restrictions in the type of shareholders and shareholder residence requirements.
It must be noted that in a partnership or LLC, the transfer of more than 50% of the entity’s interests can trigger a termination of the entity.
Another notable difference between an LLC and S Corp is that an LLC has the flexibility to allocate business profits to its members in whatever proportion the members decide between themselves.
On the other hand, an S Corp can only allocate business profits and losses to its shareholders based on the shareholder’s set percentage of shares.
An LLC can take advantage of the structural benefits of an LLC while benefiting from the S Corporation taxation by making an election to be treated as an S Corp with the IRS.
S Corporation vs sole proprietorship
An S Corporation is different from a sole proprietorship in some important ways.
First and foremost, an S Corporation is a corporate entity formed by filing the state’s necessary incorporation documents.
A sole proprietorship is a person running a business under his or her name without any legal separation afforded by incorporating a business.
On the one hand, an S Corp offers the business owner personal asset protection (limited liability) whereas a sole proprietorship does not (unlimited liability).
A sole proprietorship is simple to start.
In fact, you don’t need to accomplish any formalities.
The moment you start operating a business or acting commercially, you are automatically considered a sole proprietor.
Furthermore, a sole proprietor does not have to comply with any particular state laws (unless a business license is needed or a DBA or fictitious name is registered).
An S Corporation must be formed and recognized by the state, the business owner must maintain it in good standing by complying with the state laws.
It is also costly to set up and maintain on an ongoing basis.
Where the S Corporation and sole proprietorship have a point in common is with regards to the taxation.
Essentially, both an S Corp and sole proprietorship offer pass-through taxation.
In other words, the business income is taxed directly in the hands of the business owner.
It’s important to evaluate your business’s nature, risk tolerance, budget, and future objectives to see which business structure is better for you.
S Corporation FAQ
What is a Subchapter S Corporation
A Subchapter S Corporation is a standard “corporation” that has elected to be taxed under Subchapter S of the Internal Revenue Code making it a “pass-through” entity for tax purposes.
An S Corporation can be an attractive option for small business owners offering personal asset protection along with tax advantages not offered by C Corporations.
In essence, with an S Corporation:
Who can own an S Corp
An S Corp can be owned by any American individuals being American citizens or resident aliens.
To better understand who can own an S Corp, let’s look at the S Corp ownership restrictions.
An S Corp:
- Cannot be held by partnerships
- Cannot be owned by estates and trusts (with some exceptions)
- Cannot be held by tax-exempt entities
- Cannot be held by a foreign shareholder
It’s important to properly evaluate the pros and cons of S Corp business entities to ensure you are selecting the right business structure for your specific needs.
Why would you choose an S corporation
There are many reasons why you may want to choose an S Corp over a C Corp.
The primary reasons why business owners choose to run their small business as an S Corp are the following:
- Limited liability protection
- Pass-through taxation (avoiding double taxation)
- Perpetual existence
- One layer of taxation
- Business credibility