1. The Rationale Behind S Corporation Businesses
2. How a Business Becomes an S corporation
3. Advantages of S Corporation Businesses
4. Disadvantages of S Corporation Businesses

What is an S corporation business? An S corp is a type of corporation that is not subject to double taxation by the IRS. The business enjoys pass-through status and does not pay corporate tax on its profits. All the income of an S corporation passes through to its individual shareholders, who must pay personal income taxes. S corporation businesses are typically small corporations with 100 or fewer U.S. shareholders. They are given S corporation status after submitting Form 2553 to the IRS.

The Rationale Behind S Corporation Businesses

The S corporation tax classification is available for some small corporations and limited liability companies (LLCs). It enables the business to avoid double taxation at the federal level by passing its income to the individual shareholders. The shareholders pay personal income tax for their share of the income when they file Form 1040 to the IRS. For a corporation or an LLC to be given S corporation treatment, it must meet all of the following requirements:

  • It must not have more than 100 shareholders.
  • All its shareholders must be U.S. citizens. People who are not U.S. citizens but who are legal residents of the United States are also allowed to be shareholders of S corporations.
  • It must have one type of stock, and the distribution of earnings must be based on a shareholder's stock percentage.
  • Its shareholders must not be corporations, business trusts, partnerships, or LLCs. In fact, with the exception of a few trusts and S corps, all shareholders of S corporations must be individuals.
  • It must not be an insurance company, a bank, a Domestic International Sales Corporation, or a former Domestic International Sales Corporation.
  • The shareholders of the business must have unanimously voted to file as an S corporation.

How a Business Becomes an S corporation

A business that desires to file as an S corporation should apply to the IRS using the Election by a Small Business, also known as Form 2553. The form requires a number of details from the S corporation, including the following:

  • The name of the business.
  • The effective date of S corporation treatment.
  • The signatures of all the shareholders.
  • The EIN of the corporation.

For the S corp classification to be granted for the current tax year, the business must file Form 2553 no later than March 15 for businesses that follow the calendar tax year. But business can file at any time of the current tax year if they want S corp status to be effective starting from the following tax year.

Advantages of S Corporation Businesses

S corp treatment brings a number of benefits to a business:

  • Tax Savings. A business that has S corporation treatment does not pay federal corporate tax and stands to save its shareholders hundreds of dollars in taxes every year. Corporate tax that is levied on C corporations is charged at a rate of up to 21 percent of the corporation's profits.
  • Limited Liability Protection. S corporations give limited liability protection to their shareholders. The shareholders can, therefore, invest in the business without worrying about the possibility of losing their personal assets because of the business.
  • Perpetual Existence. S corporations are independent of the shareholders and can continue to exist even after the death of the shareholders.
  • Simple Accounting Methods. Unlike big C corporations, which are required to use complicated accrual accounting methods, S corps can use simple cash accounting methods unless they have inventory.

Disadvantages of S Corporation Businesses

S Corporation businesses have a number of shortcomings, including the following:

  • Salaried Employee-Shareholders. If the S corporation has employee-shareholders, the business must pay the employee-shareholders a “reasonable salary.” The salary must be comparable to the salaries that similar businesses in the area pay their employees. This requirement is an extra financial burden on S corporation, many of which are relatively new businesses that have yet to turn a profit.
  • Ownership Limitations. The fact that S corporations are prohibited from having more than 100 shareholders and are not allowed to have corporate and foreign shareholders limits the possibility of expanding the business through the sale of stock.
  • Formal Structural Requirements. The requirement for S corporations to have formal structures can put stress on the resources of small corporations. S corporations are not exempt from laws that require corporations to have a board of directors, to hold annual board of directors and shareholders' meetings, and to keep records of corporate resolutions.

If you need help with your S corporation, 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.