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.

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

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.

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.

If you need help with deciding whether a C or S corporation is the right choice for your business, 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, Stripe, and Twilio.