What is S Corporation mean is an important definition to know when you want to incorporate your business. Specifically, an S Corporation is a corporation that is treated by the Internal Revenue Service (IRS) as a pass-through tax entity.

Because of this, the corporation passes through all financial activities to the shareholders of the company who will report it on their personal tax returns. The S Corp files only an informational tax return (Form 1120s) – this document lists all profits, losses, expenses, credits, and deductions from the S Corp. All of this information will be stored in the Schedule K-1, which will identify each shareholder’s percentage of shares and amount of profits/losses that the shareholder will report on his or her personal income tax return.

While the corporations">S Corp is a subchapter of a C Corporation, the S Corp is still formed in the same way by filing Articles of Incorporation with the Secretary of State. Furthermore, the S Corp will issue stock, hire directors/officers, and otherwise function in a similar manner to a C Corporation.

Advantages vs. Disadvantages of an S Corporation

There are many advantages to operating an S Corp; with these advantages come some disadvantages too. Therefore, before you choose to elect S Corp status, you should be mindful of all features of this business type to ensure that you are making the best choice for your business.

Some of the benefits include:

• Protection of personal assets, as creditors cannot go after the shareholders’ personal assets, i.e. home, car, personal bank account, etc.

• Pass-through taxation, meaning that the S Corp will not have to pay corporate taxes

• S Corp shareholders can pay themselves a reasonable salary for the work they do for the business. These shareholders are often referred to as shareholder-employees.

• S Corp shareholders can also receive tax-free dividends, which will help offset the amount of money to be taxed by reducing the reasonable compensation and paying oneself in the form of a dividend.

• Ease of transferring ownership, as S Corp shareholders can freely transfer their rights in the corporation with no tax implications and no requirement for adjusting property basis.

• Cash method of accounting, whereas C Corps must use an accrual method of accounting. Note that if an S Corp has inventory, then it must use the accrual method.

• Increased credibility, as potential customers, vendors, and financial institutions might be more likely to do business with an S Corp.

With some of the advantages come disadvantages, as all business structures have certain limits and restrictions. Some of these disadvantages include ongoing fees, as corporations in general have additional fees that other business structures, like the sole proprietorship or general partnership, don’t incur.

Another disadvantage is the fact that the S Corp election can be disqualified if you make any mistakes in the stock ownership or filing requirements for the S Corp. The S Corp must maintain a calendar year as opposed to a fiscal year, which is easier to maintain for other business structures. There are also stock restrictions, as S Corps can offer only one class of stock and have no more than 100 shareholders.

Furthermore, foreign ownership is not allowed, nor can other businesses act as shareholders in the S Corp. Certain banks, insurance companies, and domestic international sales companies cannot file as S Corps.

Another significant disadvantage is the greater scrutiny over an S Corp, as the IRS closely monitors the amount of compensation that each shareholder-employee is given, and takes into account multiple factors for determining what constitutes reasonable compensation.

Some other disadvantages include the following:

• An S Corp cannot easily allocate income or losses to specific shareholders since there is only one class of stock; a partnership or LLC, however, can allocate the percentage of income/loss in the operating agreement as they so choose.

• The S Corp’s accumulated adjustment account is more difficult to maintain, as a tax professional will need to assist in the oversight of this account.

• Shareholders who are in a higher tax bracket will pay more in taxes, and such shareholders who don’t participate in the business cannot deduct losses.

• Fringe benefits are taxed on those shareholder-employees who own more than 2% of the S Corp.

If you need help learning more about the S Corp and its many features, 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, Str