Key Takeaways

  • S corporation tax classification is not a business entity type but a federal tax election under Subchapter S of the Internal Revenue Code.
  • Eligible domestic corporations (and certain LLCs) can elect S corp status by filing IRS Form 2553 to receive pass-through taxation benefits.
  • S corporations avoid double taxation — profits and losses flow through to shareholders’ personal returns — but they must still file Form 1120-S and issue Schedule K-1s to shareholders.
  • Shareholders who work for the business must receive reasonable compensation subject to payroll taxes before receiving profit distributions.
  • Strict eligibility rules (such as the 100-shareholder limit and one class of stock requirement) must be met to maintain S corp tax classification.
  • S corps can save on self-employment taxes but also come with compliance costs, IRS scrutiny, and potential state-level taxes or fees.

An S class corporation is often a good choice for small business owners because of its liability protection and advantageous tax status. Unlike C corporations, which have profits taxed at both the corporate and individual levels, S corporations pass through profits and losses to shareholders, where they are taxed only once.

What Is an S Corporation?

S corporation is a tax status with the IRS that can be elected by corporations that issue only one class of stock for fewer than 100 eligible shareholders. These must be domestic individuals or specific trusts or estates, and may not be non-resident aliens, corporations, or partnerships. Certain insurance companies, financial institutions, and domestic international sales corporations are not eligible for S corp status.

S corporations are created by submitting documents known as articles of organization to the Secretary of State. This business type provides shareholders with limited liability, which means their personal assets cannot be seized to settle business financial obligations or debts.

If your business plans to go public or issues multiple classes of stock, a C corporation may be a more appropriate entity.

Understanding S Corporation Tax Classification

It’s important to understand that an S corporation is not a separate legal entity type — it’s a federal tax classification under Subchapter S of the Internal Revenue Code. This means that a business must first be formed as a corporation or LLC at the state level and then elect S corporation status by filing IRS Form 2553. The election must generally be filed within 75 days of the beginning of the tax year the election is to take effect, though late elections may sometimes be accepted with reasonable cause.

Under this classification, the corporation’s income, deductions, and credits “pass through” to shareholders, who report them on their individual tax returns. As a result, the company avoids the double taxation faced by C corporations, which pay taxes on profits at the corporate level and again when profits are distributed as dividends.

Only certain businesses are eligible for this election. To qualify, an entity must:

  • Be a domestic corporation or LLC.
  • Have no more than 100 shareholders.
  • Issue only one class of stock.
  • Have shareholders who are U.S. citizens or resident individuals, certain trusts, or estates (not partnerships or corporations).

If these conditions are violated, the IRS may revoke S corporation status.

What Are the Advantages of Forming an S Corporation?

Some of the reasons your business may want to form as an S corporation include:

  • Increased credibility with employees, customers and potential customers, investors, and suppliers, since incorporating shows a strong commitment to the business
  • The ability for shareholders to be employees and draw salaries as well as receive dividends and other tax-free distributions
  • The ability to reduce self-employment tax liability and generate deductions by classifying distributions as either dividends or salaries
  • The ability to use business losses to offset other individual income
  • The ability to transfer interests freely without negative tax consequences, adjusting property basis, or being subject to complicated accounting rules
  • The ability to attract investors by issuing stock
  • Perpetual existence even if an owner dies or leaves the company
  • Annual tax filings instead of quarterly filings as with other types of corporations

Tax Benefits and Filing Obligations

The pass-through nature of S corporation taxation is one of its most attractive features. It allows business profits (and losses) to be reported on the owners’ individual tax returns, often leading to significant tax savings. Additionally, shareholder-employees can receive reasonable salaries (subject to payroll taxes) and take remaining profits as distributions, which are typically not subject to self-employment tax.

However, S corps still have important tax filing responsibilities, including:

  • Form 1120-S: The S corporation’s annual tax return reporting income, deductions, and credits.
  • Schedule K-1: Issued to each shareholder, reporting their share of the company’s income, deductions, and credits.
  • Payroll filings: Required for any shareholder-employees receiving wages.

In addition, while federal tax law allows S corporations to bypass corporate-level tax, some states do not recognize the S election and may still impose franchise taxes, excise taxes, or minimum fees.

What Are the Disadvantages of S Corp Status?

You may not want to form an S corporation for the following reasons:

  • Payments distributed to shareholders are scrutinized by the IRS to ensure they are classified appropriately. If wages are wrongly classified as dividends, the business will lose a deduction; if the opposite is true, the business will pay additional employment taxes.
  • S corporation status can be terminated for errors in consent, election, notification, stock ownership, or filing.
  • Fees are required for filing S corp election with the secretary of state and to hire a registered agent. However, these fees are usually minor and can be deducted as business expenses.
  • Only U.S. citizens and permanent residents can be S corp shareholders.
  • Some states charge ongoing franchise tax and annual reporting fees.

Compliance and IRS Scrutiny

While the S corporation tax classification can provide significant savings, it also subjects businesses to heightened IRS oversight. One key focus area is reasonable compensation: shareholder-employees must be paid a fair market salary before profits are distributed. Misclassifying wages as distributions can lead to audits, penalties, and back taxes.

Additionally, S corporations must maintain strict adherence to eligibility rules. Exceeding the shareholder limit, issuing multiple classes of stock, or transferring shares to an ineligible shareholder can all jeopardize S corporation status, potentially resulting in a costly reclassification as a C corporation. Businesses should also plan for increased administrative tasks, including maintaining formal records, holding regular board meetings, and carefully managing payroll compliance.

How Are C and S Corporations Similar?

For a C corporation to elect S corporation, you must file IRS Form 2553 and adhere to all associated guidelines. Similarities between S and C corporations include the following:

  • Both offer limited liability protection.
  • Both are created at the state level and treated as separate legal entities from the owners.
  • Both are established by filing articles of incorporation with the secretary of state.
  • Both are owned by shareholders and overseen by a board of directors elected by the shareholders.
  • Both are managed by officers elected by the directors.
  • Both must adhere to corporate formalities including issuing stock, adopting bylaws, holding regular meetings for shareholders and directors, paying annual fees, and filing annual reports.

How Are These Corporations Different?

Although they have many similarities, these corporate entities have several important differences:

  • C corporations are taxed as separate entities and must pay taxes on profits both at the corporate level when they are earned and at the individual level when distributed as dividends. S corporations avoid this double taxation; they are treated as pass-through entities and profits and losses are reported on each shareholder's individual tax return.
  • C corporations are not subject to restricted ownership, while S corporations are bound by the restrictions described above.
  • C corporations can issue many classes of stock, while S corporations are limited to one.

S Corporation Election for LLCs

While the S corporation election is most commonly associated with traditional corporations, LLCs can also elect to be taxed as S corporations if they meet the eligibility requirements. This is often done to reduce self-employment tax burdens while retaining the flexible management and ownership structure of an LLC.

To make the election, the LLC must file Form 2553 and follow the same rules as a corporation electing S status. Once approved, the LLC will be treated as an S corporation for tax purposes — profits and losses will pass through to members, and members working in the business must receive reasonable compensation.

Frequently Asked Questions

  1. Is an S corporation a business entity type?
    No. An S corporation is a tax classification, not a legal structure. A business must first form as a corporation or LLC and then elect S corporation status with the IRS.
  2. How do I elect S corporation tax classification?
    File IRS Form 2553 within 75 days of forming your business or the start of the tax year you want the election to take effect.
  3. Do S corporations pay corporate income tax?
    Generally no. S corporations are pass-through entities, so income is reported on shareholders’ personal tax returns. However, some states impose separate entity-level taxes.
  4. What is “reasonable compensation” in an S corporation?
    Shareholders who work in the business must be paid a fair market salary for their services before taking additional profit distributions.
  5. Can an LLC choose S corporation tax classification?
    Yes. If eligible, an LLC can elect S corporation status by filing Form 2553, potentially reducing self-employment taxes while maintaining LLC flexibility.

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