S Corporation

What Is an S Corporation?

An S corporation (also known as an S Corp or an S Subchapter) is a legal entity that provides the tax advantages of a partnership while offering the limited liability protections of a corporation. The business structure gets its name from the S Subchapter of Chapter 1 of the United States Internal Revenue Code.

To become an S Corporation, a business must begin the incorporation process by submitting its Articles of Incorporation or Certificate of Incorporation to its home state's Secretary of State's Office along with the appropriate fee.

After the incorporation process is complete, all company shareholders must sign and submit IRS Form 2553 to order to receive the S Corporation designation. From that point on, the corporation's taxes are handled by its partners on their individual income tax returns.

According to the IRS, the requirements for becoming an S corporation are the following:

  • The business must be domiciled in the United States.
  • Shareholders may include individuals, some types of trusts, and estates but may not include partnerships, other corporations, or people who are not U.S. citizens.
  • The business must have 100 or fewer shareholders.
  • The business must have only one class of stock.

Additionally, certain financial institutions, insurance companies, and domestic, international sales corporations are not allowed to structure as S Corps.

How Does an S Corp Work?

In many respects, an S Corporation works the same way as any corporation. An S corp must establish a board of directors, corporate officers, by-laws, and management structure. This type of corporation also issues shares of company stock. Owners cannot be held liable for legal or financial claims against the company.

The primary difference between an S corp and other corporate structures is that it is not federally taxed on most of the earnings it generates and distributes. Shareholders pay taxes on the funds at their ordinary-income rates. S corps must distribute IRS Schedule K-1 to its shareholders, listing their annual profits or losses from the company, and file IRS Form 1120-S each year at tax time.

What's the Difference Between an LLC and an S Corp?

Although many people discuss LLCs (limited liability companies) and S Corporations as if they are two types of the same entity, the two terms refer to distantly different aspects of a business.

An LLC is a business entity that offers limited liability protection. A business that isn't structured as an LLC is a sole proprietorship or partnership. As such, the proprietor or partners' personal assets are exposed to creditors and lawsuits.

To become an S corporation, a business first must register as a C corporation or an LLC and then meet the additional IRS guidelines specified above. C Corporations and LLCs pay corporate taxes on their earnings.

On the other hand, S Corp status allows business owners to be taxed as employees of the business.

What Are the Pros and Cons of an S Corp?

The most significant advantage of an S Corporation over other structures is that the IRS levies fewer taxes against S corp owners. S Corp shareholder earnings are assessed at an income level only.

Any further profits beyond what the IRS views as "reasonable salary" can be distributed to owners as dividends. The IRS assesses these earnings at a lower rate than profits and distributions subject to the self-employment income taxes of LLC owners.

The downside to forming an S Corp is that the IRS sets strict eligibility requirements. In addition, managing an S Corp requires more formality than an LLC. Owners must hold regular company meetings and report more financial information to the state, which can lead to higher state taxes.

Making the Decision to Classify as an S Corp

Deciding on the proper structure for a business need not be a one-and-done decision. It is often advantageous for a new small business to start out as an LLC. As the company and its revenues grow – along with the tax burden – it could be re-classified as an S Corporation.

It is essential to remember that the switch to an S Corporation classification must be completed by March 15 in order to be applicable for the following year. Alternately, the change must be made within 75 days of opening the LLC in order to be applicable for the year of opening. If a business has a valid reason for missing the deadline, it can apply to the IRS for late election relief.

Helpful Resources:

IRS - S Corporations

US Small Business Administration - Choose a business structure

Forbes - LLC Vs. S Corp

Cornell Law - S Corporation

IRS - Business Structures