Key Takeaways

  • An S corporation is a tax classification allowing pass-through taxation, avoiding the double taxation faced by C corporations while providing liability protection to owners.
  • To qualify, an S corp must meet IRS requirements, including having no more than 100 shareholders, all of whom must be U.S. citizens or residents, and issuing only one class of stock.
  • Advantages include liability protection, tax savings through pass-through taxation, and ease of transferring ownership.
  • Disadvantages include strict ownership restrictions, heightened IRS scrutiny, and potential state-level taxes or fees.
  • Forming an S corp involves filing Articles of Incorporation, obtaining an EIN, meeting IRS election deadlines, and complying with ongoing reporting requirements.
  • Characteristics that set S corps apart include shareholder eligibility rules, pass-through taxation, corporate formalities, and limits on stock classes.

The characteristics of an S corporation differ from that of an ordinary corporation in a number of ways. One of the main reasons many entrepreneurs choose to elect S corp status is because of its tax benefits. While it offers the same liability protection as a C corporation, an S corporation comes with certain restrictions that can limit its growth potential. It is important to weigh the pros and cons of this business structure before you make the switch.

What Is an S Corporation?

An S corporation refers to an incorporated business that is regarded as a pass-through tax entity by the IRS. Since it is a corporation, an S Corp is formed through the submission of the Articles of Incorporation to the Secretary of State or an appropriate state agency. It issues stock and adopts the same organizational structure as a C corporation, which consists of shareholders, a board of directors, and officers.

The owners of an S corporation enjoy the same liability protection as the shareholders of a corporation. This means that their personal assets cannot be used to cover business debts and other liabilities. Nonetheless, similar to a sole proprietorship or partnership, an S Corp passes most of its income and loss through to the personal tax returns of its shareholders. As such, it is not subject to double taxation like a C corporation. Each shareholder in an S corporation pays taxes on pass-through income at his or her own individual rate.

The number of shareholders in an S corp cannot exceed 100. An S corporation operates in the same way as a C corporation. It is required to pay salaries to its employees and withhold individual income, Social Security, and unemployment taxes for them. While salaries are subject to withholding, the dividends distributed to shareholders are not.

Although the pass-through tax features of an S Corp make it an attractive option, it is not fully recognized in some states and consequently taxed as a C corporation. In some states, an S corporation is required to pay annual report filing fees or other fees, which can be a significant burden for a small company.

Key Characteristics of an S Corporation

S corporations have unique characteristics that distinguish them from other business structures. The most notable features include:

  • Pass-Through Taxation – Income, losses, deductions, and credits are passed directly to shareholders, who report them on their personal tax returns. This avoids the double taxation typical of C corporations.
  • Liability Protection – Shareholders are not personally responsible for the company’s debts or legal obligations beyond their investment in the business.
  • Shareholder Limitations – S corps can have a maximum of 100 shareholders, and all must be U.S. citizens or resident individuals, certain trusts, or estates. Partnerships, corporations, and foreign investors are generally excluded.
  • Single Class of Stock – Only one class of stock is permitted, although voting rights can differ among shareholders.
  • Corporate Formalities – Like C corporations, S corps must hold regular board and shareholder meetings, keep meeting minutes, and maintain accurate records.
  • IRS Oversight – Because of their tax advantages, S corps are often subject to closer scrutiny from the IRS, particularly regarding reasonable shareholder salaries and the allocation of income and losses.

Eligibility Requirements for an S Corporation

In order to qualify for S corp status, a company must first be a corporation. If the company is a corporation, it must file IRS Form 2553 to elect Subchapter S status by the 15th day of the third month of its tax year. All shareholders are required to sign this form.

In addition, all shareholders must be U.S. citizens or residents. Estates and trusts can be shareholders of an S corporation, but sole proprietorships, partnerships, foreign investors, and certain insurance companies, domestic international sales corporations, and financial institutions are not allowed to own shares in an S Corp. Also, an S corporation is required to issue only one class of stock, but voting rights may vary. A C corporation that has been an S corporation within the past five years is not eligible.

Tax Treatment and Compliance Obligations

Once an S corporation is approved, it must adhere to specific tax and compliance requirements to maintain its status:

  • Federal Tax Reporting – S corps file an annual information return (Form 1120-S) with the IRS, reporting the company’s income, deductions, and other tax details.
  • Shareholder Tax Obligations – Each shareholder receives a Schedule K-1 reporting their share of the company’s profits, losses, and credits, which they include on their personal tax returns.
  • Reasonable Compensation Rule – Shareholder-employees must receive a reasonable salary for their work before profits are distributed. This salary is subject to payroll taxes, while distributions are generally not.
  • State-Level Taxes and Fees – Some states do not recognize S corp status and may impose corporate income taxes or franchise taxes. Others require additional annual filings or fees.
  • Ongoing Compliance – Failure to meet eligibility rules, file required returns, or pay applicable taxes can result in the termination of S corp status.

Advantages and Disadvantages of an S Corporation

Advantages

  • Protected assets
  • Pass-through taxation
  • Tax-favorable income characterization
  • Simple transfer of ownership
  • Cash method of accounting
  • Perpetual existence
  • Good investment opportunities
  • Enhanced credibility
  • Annual tax filing requirement

Disadvantages

  • Formation and ongoing fees
  • Tax qualification requirements
  • Adoption of calendar year
  • Restrictions on stock ownership
  • Closer scrutiny from the IRS
  • Less flexibility in the allocation of income and loss
  • Taxable fringe benefits
  • Recordkeeping requirements
  • Inability to acquire a foreign investor

How to Form an S Corporation

  1. Select a legal business name.
  2. Draft and submit your Articles of Incorporation to the Secretary of State or the appropriate state agency.
  3. Give out stock certificates to the original shareholders.
  4. Obtain a business license, permit, or other certificates required for your industry.
  5. Get an Employer Identification Number (EIN) by filing IRS Form SS-4 or applying at the IRS website.
  6. Obtain any other identification numbers required in your state.
  7. Apply for tax identification numbers for paying payroll taxes such as unemployment and disability taxes. Requirements may vary depending on which jurisdiction you are in, but most states require business owners to have tax identification numbers.
  8. File Form 2553 within 75 days after forming your corporation.

Frequently Asked Questions

1. What is the main difference between an S corporation and a C corporation?

The primary difference is taxation. S corporations have pass-through taxation, while C corporations face double taxation—once at the corporate level and again on dividends.

2. Can an S corporation have foreign shareholders?

No. All shareholders must be U.S. citizens or residents, certain trusts, or estates. Foreign individuals and entities are generally prohibited.

3. What happens if an S corporation violates eligibility rules?

If eligibility rules are violated, the IRS may terminate S corp status, and the business will be taxed as a C corporation.

4. Do S corporations pay federal income taxes?

Generally, no. S corporations themselves do not pay federal income taxes. Instead, income is reported and taxed on shareholders’ personal returns.

5. Are all states required to recognize S corporation status?

No. Some states do not recognize S corp status and tax the entity as a C corporation. Others may impose state-level fees or franchise taxes even if S corp status is recognized.

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