Key Takeaways

  • An S corporation structure is a tax designation that lets qualifying corporations and LLCs pass income, losses, deductions, and credits directly to shareholders.
  • S corps maintain a formal corporate governance structure, including shareholders, a board of directors, and officers, similar to C corporations.
  • Ownership is limited to 100 shareholders, all of whom must be U.S. citizens or residents, and only one class of stock is permitted.
  • Key benefits include pass-through taxation, liability protection, flexibility in profit distribution, and potential self-employment tax savings.
  • Disadvantages may include strict compliance requirements, shareholder eligibility restrictions, and limitations on fundraising.
  • Understanding the internal structure—shareholder roles, director responsibilities, and officer duties—is essential for compliance and effective business operations.

S Corporate Structure

The S corporate structure is a type of corporation. Generally, there are C and S corporations. The S corporation is a specific version of the C corporation. It is formed in the same way as the C corporation by filing the Articles of Incorporation with the Secretary of State. The S corporation is treated as a pass-through tax entity that doesn’t pay corporate income taxes. In order to elect tax status as an S corporation, the business must submit a form on the Internal Revenue Service (IRS) website. Keep in mind that a corporation or Limited Liability Company (LLC) can be treated as an S corporation for tax purposes.

How the S Corporation Structure Works

An S corporation structure functions much like a C corporation in terms of governance, but with key differences in taxation and shareholder requirements. At its core, an S corp is a corporation that has elected a special tax status under Subchapter S of the Internal Revenue Code, enabling profits and losses to pass through to shareholders without being taxed at the corporate level. This structure combines the liability protection and organizational formality of a corporation with the tax efficiency of a partnership or sole proprietorship.

The S corp structure typically includes three main components:

  • Shareholders: The owners of the company, who provide capital and receive profits or losses based on their share ownership.
  • Board of Directors: Elected by shareholders, the board oversees major decisions, sets policies, and ensures the corporation operates in the shareholders’ best interests.
  • Corporate Officers: Appointed by the board, officers such as the CEO, CFO, and secretary manage day-to-day business operations.

Although these roles mirror those of a C corporation, S corporations face specific operational restrictions. For instance, they must maintain one class of stock, hold annual meetings, keep corporate minutes, and follow state corporate governance laws. These formalities help preserve liability protections and ensure compliance with IRS regulations.

S Corp Requirements

When you initially form your corporation or LLC, it will automatically be treated as a C corporation or LLC. In order to elect status as an S corporation, you will need to meet the requirements in order to do so. Therefore, before submitting the form for such election on the IRS website, you’ll want to first confirm that you can do so.

Such requirements include the following:

  • The business must first be eligible to be taxed as an S corporation, i.e. corporation or LLC
  • The business can’t have more than 100 shareholders or members
  • Such shareholders or members must be individuals, estates, exempt businesses, or certain trusts
  • The shareholders can’t be other corporations, partnerships, or LLCs
  • The shareholders cannot be nonresident citizens or aliens
  • The S corporation can have only one class of stock
  • The S corporation cannot operate as a financial institution, insurance company, or domestic sales corporation
  • The business’s tax year must end on December 31
  • All of the shareholders must agree to operate as an S corporation

Ownership and Shareholder Rules

The ownership rules are central to maintaining an S corporation’s status. To qualify, the business must meet all of the following conditions:

  • Shareholder Limits: The corporation cannot exceed 100 shareholders.
  • Eligible Shareholders: Only U.S. citizens or resident individuals, certain estates, and specific trusts are permitted. Other corporations, partnerships, or nonresident aliens cannot hold shares.
  • Stock Requirements: S corporations may issue only one class of stock, ensuring that all shareholders have equal distribution rights to profits and losses.
  • Business Activity Restrictions: S corporations cannot operate as certain financial institutions, insurance companies, or international sales corporations.

If an S corporation fails to meet any of these conditions, it risks losing its S status and reverting to a C corporation for tax purposes.

S Corp Advantages

There are several advantages to operating an S corporation. While some companies might not fare well operating as an S corporation, smaller business owners who meet all of the above-mentioned requirements will significantly benefit from the many advantages that the S corporation offers, which include:

  • Liability protection
  • Pass-through taxation
  • Perpetual existence
  • Annual tax requirement as opposed to quarterly tax requirements
  • Shareholder compensation
  • Ease of ownership transfer
  • Cash method of accounting

Similar to other business structures, including the C corporation and LLC, the S corporation provided liability protection for the owners and shareholders. This will ultimately protect their personal assets in the event that creditors bring a legal suit against the business for outstanding debt. Keep in mind that some exceptions exist to this rule. For example, if the shareholder or owner engages in fraudulent or illegal conduct, personally guarantees a loan, or holds the business out as his own, then the creditor or plaintiff might be able to pierce the corporate veil and hold the shareholder or owner personally liable.

The S corporation operates as a pass-through tax entity, similar to that of an LLC. The business profits and losses will pass through to the shareholders who will report it on their individual tax returns. Unlike the S corporation, the C corporation incurs double taxation, once at the corporate level and again at the personal level.

The S corporation, similar to that of a corporation, has a perpetual existence. Therefore, if a member becomes incapacitated, quits, or dies, the business will continue operating. This can be especially helpful for an LLC choosing to operate as an S corp for tax purposes, since LLCs don’t have a perpetual existence.

The S corporation has an annual tax-filing requirement, at which point the shareholders are taxed. However, a C corporation must pay taxes on a quarterly basis.

The S corporation shareholders can operate as employees of the corporation and pay themselves a reasonable salary for their work. But be mindful that the compensation must be reasonable and cannot be too low to simply reduce tax implications.

The S corporation also offers ease when transferring ownership. Shares can be easily transferred to someone else. However, an LLC membership transfer can be much more difficult and might even trigger dissolution of the LLC. Furthermore, S corporation doesn’t have to make any adjustments to its property basis or comply with complex accounting rules when shares are transferred.

The S corporation can use the cash method of accounting whereas C corporations must use the accrual method. The only requirement here is that the S corporation has gross receipts of no more than $5 million. Additionally, the only time that the S corporation would have to use the accrual method is if it has inventory.

Potential Drawbacks and Compliance Challenges

While the S corporation structure offers substantial advantages, it’s not without challenges. Business owners should carefully weigh these before making the S election:

  • Strict Compliance Requirements: S corporations must observe corporate formalities, including annual meetings, recorded minutes, and state reporting requirements, which can increase administrative overhead.
  • Eligibility Restrictions: The 100-shareholder cap and citizenship requirements limit growth and make S corps less suitable for companies seeking large-scale investment.
  • One Class of Stock Limitation: Restricting the company to a single class of stock can make it harder to attract investors or issue different types of equity compensation.
  • IRS Scrutiny on Salaries: The IRS closely monitors shareholder-employee salaries to ensure they are “reasonable.” Paying unreasonably low salaries to reduce payroll taxes can trigger audits and penalties.
  • Limited Flexibility for Certain Businesses: Companies in industries like banking or insurance may not qualify for S corporation status at all.

Despite these drawbacks, for many small to mid-sized businesses that meet the requirements, the S corporation structure remains one of the most tax-efficient and legally protective options available.

Frequently Asked Questions

  1. How is an S corporation different from a C corporation?
    An S corporation is taxed as a pass-through entity, meaning profits and losses are reported on shareholders’ personal tax returns, whereas a C corporation is taxed separately and faces double taxation.
  2. Can an LLC elect to be treated as an S corporation?
    Yes. A qualifying LLC can elect S corporation status by filing IRS Form 2553, allowing it to benefit from pass-through taxation while retaining limited liability protection.
  3. What happens if an S corporation violates ownership rules?
    If the company exceeds 100 shareholders, issues multiple classes of stock, or admits ineligible shareholders, it will lose its S corporation status and revert to being taxed as a C corporation.
  4. Are S corporation owners considered employees?
    Yes. Shareholder-owners who actively work in the business are considered employees and must receive a reasonable salary subject to payroll taxes.
  5. Can an S corporation go public or attract venture capital?
    Generally, no. The shareholder and stock restrictions make S corporations unsuitable for going public or raising significant venture capital. Businesses with those goals often convert to C corporations.

If you need help learning more about s corporation structure, 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.