Key Takeaways:

  • An S Corporation (S Corp) is a tax designation that provides liability protection like a corporation but is taxed as a pass-through entity.
  • S Corps avoid double taxation, as profits and losses pass through to shareholders.
  • There are strict IRS requirements to qualify as an S Corp, including a limit of 100 shareholders and only allowing certain types of entities as shareholders.
  • Limited liability protects shareholders from personal responsibility for business debts and legal actions, but there are exceptions.
  • S Corps are subject to reasonable compensation rules, meaning that owners who perform services must receive a fair salary before taking distributions.
  • Compliance failures, such as improper filings or excessive shareholder distributions, can lead to an S Corp losing its tax status.
  • State taxation of S Corps varies, and some states impose franchise taxes or additional requirements.

The liability of an S-corporation is something that you must consider before you elect this tax status. An S-corporation gives you the tax benefits of a sole proprietorship or partnership as well as the limited liability protections of a corporation.

What Is an S-Corporation?

When incorporating a business, an S-corporation is one of three choices, all of which are beneficial in certain regards. As an alternative to setting up an S-corp, you could incorporate your business as a C-corporation or form a Limited Liability Company (LLC). Every business owner will need to decide how their business will be taxed. For many small businesses, the best choice is deciding to be taxed as an S-corporation.

In terms of federal taxation, an S-corp is a type of pass-through entity that has elected special tax status with the corporations">IRS. The “S” can also be used to refer to the tax code section that regulates these types of corporations. Forming an S-corp requires filing specific documents with your Secretary of State, including Articles of Incorporation. S-corporations issue stock just like a C-corp. They will also be governed like a traditional corporation and will have officers, directors, and shareholders.

Choosing to incorporate your business can protect you from the actions of other shareholders and employees. This makes corporations different from partnerships and sole proprietorships, as your employees and shareholders are considered extensions of yourself with these entities, meaning you can be held liable for their actions. If you run a sole proprietorship or partnership and your partner or employee causes damages, you can be sued to cover these damages.

An S-corporation is a good choice for businesses that offer and possess several characteristics:

  • No need for expensive equipment purchases
  • Generally low startup costs
  • The ability to earn a large amount of money with minimal effort

If you find that an S-corporation does not meet your needs, you can easily transition to a C-corp after taking advantage of the S-corp's ability to pass-through losses. 

How S Corps Differ from Other Business Structures

When deciding between an S Corp, C Corp, or LLC, it's crucial to understand the differences:

  • S Corps vs. C Corps
    • Both offer limited liability protection, but C Corps are subject to double taxation, while S Corps avoid this by passing profits through to shareholders.
    • C Corps have no shareholder restrictions, while S Corps are limited to 100 shareholders, all of whom must be U.S. citizens or residents.
  • S Corps vs. LLCs
    • LLCs offer flexibility in taxation—they can choose to be taxed as a sole proprietorship, partnership, or corporation.
    • S Corps require corporate formalities, including regular board meetings and officer designations, while LLCs have fewer formal requirements.
    • Self-employment taxes are typically lower in an S Corp since only salaries (not distributions) are subject to payroll taxes.

S-Corporation Liability

If you are a shareholder that owns part of an S-corp, it's important to understand the liability to which you may be exposed. S-corporations are simply traditional corporations that have elected a special IRS tax status.

Instead of being taxed as a corporation, S-corporations are taxed like partnerships. However, S-corporations retain most of the limited liability protections enjoyed by regular corporations.

When discussing S-corporation liability, there are two issues that you must keep in mind. First, it's important to understand how shareholders may be liable for the obligations and actions of the corporations. Second, you need to understand how an S Corporation can be liable for work performed on the corporation's behalf.

If an S-corporation was originally a partnership or sole proprietorship that had not been incorporated, the personal assets of the owner are still at risk from company debts or lawsuit judgments against the corporation. However, this risk will not be shared by shareholders or partners that join the business after it has elected S-corp status.

If the shareholder of an S-corp uses their personal assets as collateral when obtaining a business loan, these assets can be lost if the shareholder defaults on the loan.

Losing personal assets when using them as a collateral for a business loan can occur with several different lending sources:

  • Second mortgages
  • Home equity loans
  • Personal credit cards

While the limited liability of S Corporations can protect you from the actions of your shareholders or employees, these protections don't protect you from being sued for your own actions. However, as long as there is no proof that fraud was sanctioned by the corporation, shareholders will be protected from sharing each other's liability.

If the actions of an employee cause damages, the corporation can be held responsible. Typically, the corporation will only be responsible for employee actions if those actions were authorized by the company or if the actions were related to the employee's normal duties. This means that if the employee is acting for personal reasons, then the corporation will usually be protected if any damages occur. On the other hand, if an employee injures someone while performing their normal responsibilities, the corporation will be liable. Also, if you formed your corporation incorrectly, you won't be protected from personal lawsuits.

Make sure you're following your state's laws for corporations to maintain your liability protections.

How S Corps Differ from Other Business Structures

When deciding between an S Corp, C Corp, or LLC, it's crucial to understand the differences:

  • S Corps vs. C Corps
    • Both offer limited liability protection, but C Corps are subject to double taxation, while S Corps avoid this by passing profits through to shareholders.
    • C Corps have no shareholder restrictions, while S Corps are limited to 100 shareholders, all of whom must be U.S. citizens or residents.
  • S Corps vs. LLCs
    • LLCs offer flexibility in taxation—they can choose to be taxed as a sole proprietorship, partnership, or corporation.
    • S Corps require corporate formalities, including regular board meetings and officer designations, while LLCs have fewer formal requirements.
    • Self-employment taxes are typically lower in an S Corp since only salaries (not distributions) are subject to payroll taxes.

Taxation and Compliance Requirements for S Corps

S Corps must comply with strict IRS regulations to maintain their tax status:

  • Annual Tax Filings: S Corps must file Form 1120S, the U.S. Income Tax Return for an S Corporation, along with shareholder K-1 forms.
  • Reasonable Compensation: Owners who work in the business must take a fair salary before receiving distributions.
  • State-Level Requirements: Some states do not recognize S Corp status and tax them as C Corps or require additional fees (e.g., California imposes an annual franchise tax).
  • Restrictions on Ownership: S Corps cannot have non-resident alien shareholders, corporations, or certain trusts as shareholders.

Failure to comply can result in the loss of S Corp tax status, leading to default taxation as a C Corporation with double taxation consequences.

Frequently Asked Questions (FAQs)

1. What are the benefits of choosing an S Corp over an LLC? S Corps offer liability protection, avoid double taxation, and reduce self-employment taxes. However, they have stricter compliance requirements compared to LLCs.

2. Can an S Corp be held liable for an employee’s actions? Yes, if the employee is acting within the scope of their job duties, the S Corp can be liable for damages or legal claims.

3. What happens if an S Corp violates IRS regulations? The IRS can revoke S Corp status, leading to taxation as a C Corporation, which subjects the business to double taxation.

4. Are all states required to recognize S Corp status? No, some states impose franchise taxes, while others, like California, tax S Corps similarly to C Corps. Always check state-specific laws.

5. Can an S Corp have foreign shareholders? No, only U.S. citizens or resident aliens can be shareholders in an S Corp. Non-resident alien ownership disqualifies S Corp tax status.

If you need help understanding the liability of an S-corporation, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.