Updated November 24, 2020:

Running an S corporation (S Corp) comes with risks, rewards, and caveats. S Corps benefit service-oriented organization the most.  Still, all business owners must take the time to get to know the pros and cons of forming an S Corp.

S Corporation Basics

Most small-business owners prefer an S corporation instead of the typical standard (or C) corporation. They are drawn to the tax benefits they get from an S corporation while they still get to enjoy C corporation liability protection. S Corps do not recognize income and losses. Instead, the shareholders include the profits or losses on their personal tax returns. They are not subject to double taxation like other entities.

To form an S Corporation,

  • You must be a domestic entity and elect to be treated as such.
  • You are limited to less than 100 shareholders.
  • You can only have the following shareholders: individuals, estates, specific partnerships and trusts, tax-exempt charitable organizations, and other S corporations (as long as you are the sole shareholder).
  • All your shareholders must be US citizens.
  • You can only have one class of share.
  • All shareholders must have equal authority for distributions and liquidation evens (though they can have different share voting rights).

There are other guidelines S Corps must follow. They are outlined in IRS Form 2553. Furthermore, S Corp small business owners with no inventory can use the less complicated cash method of accounting. With the cash method of accounting, income is not taxed until the business receives it. Likewise, the business cannot claim expenses until they are paid.

There are also some disadvantages to having an S Corp. Your legal and accounting costs are just as much as it would be for a C corporation since S corporations are governed by the same election guidelines which mean:

  • They must submit register their articles of incorporation.
  • Meet with their board of directors and shareholders, record minutes, and have shareholders vote on critical corporate decisions.
  • They have the same tax and advisement cost as a standard corporation.

All business entities, including S corporations, must submit certain tax forms including their annual tax return. For S corporations, it is IRS Form 1120S. They must also report profits and losses via the Schedule K-1 form. Though S Corps must file this paperwork, it is the very reason business owners would choose these types of entities — tax breaks.

Business entities like LLCs and Sole Proprietorships must pay self-employment taxes on all income. On the other hand, S corporation working shareholders only pay self-employment on their earned income and not dividend distributions they receive as a shareholder—with one caveat: corporate officers that work for the corporation must receive a "reasonable salary" per IRS mandate. Since the salary is considered "personal income", the IRS can collect tax revenue from working shareholder salaries and is subject to payroll taxes.  

Gaining and Revoking S Status

Corporations are limited in the amount of time they get to make a Subchapter S election. They have exactly two months and 15 days after the first taxable year to make this election. S corporation treatment varies from state to state. 

Some states do not recognize the subchapter S designation which means they receive the same treatment as standard corporations. While other states recognize this election. Additionally, some states require additional S corporations to state-specific forms to recognize the designation. Check with your lawyer to check your state's Subchapter S election requirements. You can have your subchapter S status revoked by not meeting eligibility requirements or by not filing with the IRS on time.

How to Run S Corporations

To differentiate between your income and expenses as an employer versus a shareholder:

  • Apply for a tax ID for your business.
  • Open a business account in your S-Corp's name so that you are not mixing personal income and expenses with business transactions.
  • Protect your business assets and profits with the appropriate amount of business insurance.

Remember, while your corporate status protects your personal assets, it does not protect the business from losses. With that said, survey your business to see if you need other insurances like workman's compensation insurance, business liability insurance, and company insurance.

If you need help with an S Corp,  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.