An S corp is any business that chooses to pass corporate income, losses, deductions, and credits through shareholders for federal tax purposes, with the benefit of limited liability and relief from double taxation.
An S corporation is a variation of a corporation within Subchapter S of Chapter 1 of the Internal Revenue Code. To be an S corporation, your business needs to be set up as a corporation by filling and submitting documents like the Articles of Incorporation or Certificate of Incorporation to the appropriate government authority, along with the applicable fee.
Once the incorporation process is complete, all shareholders must sign and submit Form 2553 to be granted the S corporation designation. From there, taxes are handled by the corporation's shareholders on their individual returns.
Key Takeaways
- An S corporation, also known as an S subchapter, refers to a type of legal business entity.
- Requirements give a corporation with 100 shareholdersor less the benefit of incorporation while being taxed as a partnership.
- Corporate taxes filed under Subchapter S may pass business income, losses, deductions, and credits to shareholders.
- Shareholders report income and losses on individualtax returns and pay taxes at ordinary tax rates.
- S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations.
Qualifying as an S Corporation
According to the Internal Revenue Service (IRS), to qualify for S corporation status, the corporation must meet the following requirements:
- Be domiciled in the United States
- Have only allowable shareholders, which may include individuals, certain trusts, and estates, and cannot include partnerships, corporations, or non-resident alien shareholders
- Have 100 or fewer shareholders
- Have just one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations, which are forbidden the S corp structure)
Avoiding Double Taxation
According to the IRS:
Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income.
This is one of the most appealing features of an S corporation. By contrast, the taxable income of a regular corporation is subject to double taxation, first at the corporate level, and then at the individual income tax level.
For example, say a regular "C" corporation has four shareholders with equal shares and reports taxable income of $440,000 in a year on which the company needs to pay a corporate tax of 21% ($92,400). The company subsequently distributes the remaining amount ($347,600) among the four shareholders with each shareholder getting $86,900, which is again taxed.
S corporations have an advantage here, as they are taxed once. The corporate income, loss, credits, and deductions are “passed through” to shareholders for tax purposes. The shareholders then report the same on their personal income tax returns (Form 1040), which are accordingly taxed at the applicable individual income tax rate. Thus an S corporation is exempt from paying taxes at the corporate level.
This advantage is not granted to all S corporations, however, as different states and municipalities have variations in tax laws. New York City, for example, imposes a full corporate income tax of 8.85%, though if that business can prove that it has business outside of the city, that portion can be exempt.
California levies a similar charge—a franchise tax—which is 1.5% on net income, or a minimum of $800.
Form 1120-S is used to file the U.S. Corporation Income Tax Return for an S corporation. Shareholders' profits, losses, and deductions are documented in Schedule K-1.
Note
Dividends are double taxed because the income of a company is taxed and then when the dividend money is passed to the shareholder, they have to pay taxes on their individual returns.
More Advantages of an S Corp Structure
Self-Employment Tax
Employing an S corporation structure can lower the self-employment tax. The taxable business income can be split into two components—salary and distribution. Here, only the salary component attracts the self-employment tax, thus reducing the overall tax liability. While in the case of a sole proprietorship, partnership, or LLC, the self-employment tax is applicable on the entire net business income.
The second component of the income comes to the shareholder (owner) as distribution, which is not taxed. By making a “reasonable” division between the two components, there can be a substantial amount of tax savings. It's considered good to draw approximately 60% of the company's income as salary since any unreasonable division could be construed as an attempt to avoid taxes.
Independent Life
Unlike a sole proprietorship or LLC (LLC without necessary inclusions in its operating agreement) where the life of the business is linked to the owner’s life or exit from business, an S corporation has an independent life span. Its longevity is not dependent on shareholders, whether they depart or stay, thus making it relatively easy to do business and look at long-term goals and growth.
Protective Shield
Personal assets of shareholders are protected by the structure of an S corp. No shareholder is personally responsible for the liabilities and debts of the business. Creditors have no claim on the personal assets of shareholders in order to settle business debt, whereas personal assets are vulnerable under sole proprietorships or partnerships.
Transfer of Ownership
It's relatively easy to transfer interest in an S corporation as compared to other forms of business entities. The sale can be structured in two ways:
- An outright sale, where the buyer makes the purchase in one go and there is an immediate transfer of ownership
- A gradual sale, where the purchase is done over a period of time. Whichever way is chosen, the transfer of ownership is facilitated through a written sales agreement that formalizes the whole process
The same ease is not there in a sole proprietorship, which is very simple to form but equally hard to sell to another party.
Credibility
An S corporation has high credibility among potential vendors, customers, and partners, as an S corporation is a recognized business structure.
Some Disadvantages of S-Corps
S corporations also carry with them some possible disadvantages. Here is an overview:
Protocols
This form of business entity requires many protocols to be followed, like scheduled meetings of directors and shareholders, meeting minutes, formalized by-laws, maintenance of proper records, and more recordkeeping requirements.
Compensation Requirements
As discussed earlier, shareholders split corporate income into two parts (salary and distribution). Here, the IRS keeps a closer watch and takes notice of abrupt combinations, such as low salary-high distribution. If the IRS observes this, then it makes changes accordingly, moving a larger sum under “salary,” which can lead to unexpectedly higher taxes.
Extra Work and Cost
As compared to a sole proprietorship, S corporations need more accounting and bookkeeping, which can require the help of a qualified accountant, adding to the costs.
In addition, there might be more banking and legal advice needed for business loans, taxation, and other issues. Even state governments and agencies levy more fees and taxes.
For example, Massachusetts levies an extra tax on profits once the company reaches a specified size.
Added Restrictions
The IRS has laid down many criteria to qualify for the S corporation status which restricts the type and number of shareholders. For example, foreigners can't be shareholders; all the owners need to be U.S. citizens or permanent residents. Even during a transfer of ownership, the transfer can only be done to specified individuals, an estate, or trusts.
Noncompliance can lead to the IRS taking away S corporation status. This restricts the flexibility of the business. In addition, income and losses need to be allocated according to the percentage of ownership, unlike an LLC or partnership where the allocation can be different by setting it up in the operating agreement.
If you have a larger, faster-growing company, sticking with the C corporation might be a better fit. That structure allows multiple classes of stock and no limits on shareholders.
Tax Changes
For 2024, the federal income top rate for individuals who earned $609,350 or more ($731,200 for joint filers) is 37% (which is less than the corporate rate).
Such changes highlight the necessity to monitor changes to tax rates and laws that could make the S corp structure less attractive compared to the regular corporate structure.
What Defines an S Corporation?
An S corporation is a combination of a corporation and a partnership. Through its structure, income, credits, deductions, and losses pass through directly to the shareholders, which avoids the issue of double taxation (once at the corporate level and then again at the individual level). An S corp can only have 100 or less employees.
What Is the Difference Between an S Corp and an LLC?
Some of the differences include the number of employees; S corps can only have 100 or less whereas LLCs can have an unlimited number, citizen/resident status; S corps are not allowed non-U.S. citizens/residents, whereas an LLC they can be non-U.S. citizens/residents, ownership; S corps can not be owned by other businesses such as LLCs, trusts, and corporations, whereas LLCs can, and stock type; S corps can not issue different classes of stocks with different financial rights whereas LLCs can.
Why Is It Called an "S" Corporation?
It is called an "S" corporation because of Subchapter S of the Internal Revenue Code.
The Bottom Line
When compared with sole proprietorships or partnerships, S corporations have an edge on aspects like transfer of ownership and continuance of the business. However, S corporations can be disadvantageous for a single-owner, small business.
Before opting for an S corporation, make sure to check about rules and regulations, and especially tax treatment (and any additional fees and taxes) in your state or city. Also, it would be wise to consider hiring an attorney who can advise you on corporate structures. For more information, see the IRS's information page on S corporations.
