What does S-Corporation mean? This is a corporation that's elected special status with the IRS for tax purposes. Its name comes from the Subchapter S in the Internal Revenue Code.

An Overview of S-Corps

S-Corps are treated as pass-through entities, and the S-Corp status is for small businesses. 

You can create a corporation by filing an Articles of Incorporation with your Secretary of State or similar government agency.  After incorporating, you'll file form 2553 with the IRS to elect S-Corp status. Certain requirements must be met for your corporation to elect S-Corp.

S-Corps are very much like C-Corps in that they issue stock and are governed like corporations. S-Corps have shareholders, officers, and directors. Shareholders (owners) in S-Corps enjoy the same liability protection that C-Corp shareholders do. A shareholder's personal assets can't be seized to satisfy business debts.

Similar to a partnership or sole proprietorship, however, income and losses in an S-Corp pass through to company shareholders. There's no "double taxation" in an S-Corp. This is different from a C-Corp, which is taxed at the corporate level and at the individual shareholder level.

S-Corp shareholders are subject to individual tax rates on the business's income (or losses) that is passed through to them.

Advantages of S-Corporations

The advantages of operating an S-Corp usually outweigh the disadvantages. If you decide to terminate the business or transfer ownership, S-Corp status can be very beneficial. The advantages an S-Corp offers aren't usually available to partnerships and sole proprietorships.

Some of the biggest advantages include the following.

Personal asset protection

Unless a shareholder has given an express personal guarantee, he or she is not personally responsible for the company's debts and liabilities. Creditors will not be able to go after shareholders' personal assets — such as homes or personal bank accounts — to pay off the corporation's debts.

In general, partnerships and sole proprietorships — the business and its owners — are considered the same legal entity, which leaves personal assets vulnerable.

Pass-through taxation

S-Corps don't pay taxes at the corporate level, and most states follow federal rules when it comes to S-Corp taxes. " Pass-through" taxation means business losses can offset other income on a shareholder's personal tax return. The tax savings can be very beneficial to new businesses in particular.

Tax-favorable income characterization

Shareholders in an S-Corp can be salaried employees of the company, so shareholder/employees may have less of a self-employment tax liability. In addition, they may also receive dividends and other tax-free distributions based on the extent of their investment in the business. 

Straightforward ownership transfer

You can freely transfer ownership in an S-Corp without worrying about negative tax consequences. This is different from LLCs or partnerships, where a transfer that's more than 50% could end the company.

Increased credibility

Operating as an S-Corporation can help a new company establish credibility more quickly with employees, vendors, partners, investors, and potential customers because these parties can see the formal commitment owners have made to their business.

S-Corp Eligibility Requirements

To qualify for S-Corp tax status, a corporation must meet the following criteria:

  • It cannot have more than 100 shareholders.
  • It has to be a domestic company.
  • No shareholder can be a non-resident alien.
  • All shareholders must consent to S-Corp election.
  • It can only issue one class of stock.
  • Shareholders can only be individuals and certain estates or trusts, so no LLCs, C-Corps, or other S-Corps can be owners.
  • It must file form 2553 with the IRS in a timely manner.

The S-Corp tax designation was created to help the formation of small businesses. This tax election can be very helpful for certain corporations, especially newly established ones. If your company meets all the eligibility requirements and you're fine with remaining a small corporation, you may want to consider S-Corp election.

Be aware of all potential disadvantages as well. The IRS tends to scrutinize S-Corp taxes more closely to identify potential signs of abuse. An S-Corp usually doesn't have the same flexibility in growth and investment opportunities as a C-Corp, either. These are important points to consider if your long-range plans include global expansion. In this case, remaining a traditional C-Corp would suit you better. 

If you need help understanding S-Corporations or other business types, 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.