What is an S Corporation?

An S corporation is a type of corporate business entity that allows pass-through taxation. Instead of paying corporate taxes, the S corporation definition of a pass-through entity means that the business passes its income, credits, and losses to its shareholders, who then report those corporate finances on their personal income taxes.

This business structure is the exact opposite of a C corporation, which is required to file corporate taxes.

What qualifications does a business need to become an S corporation?

Businesses wishing to be designated as an S corporation for tax purposes have to meet a list of criteria regarding the type of business, size, shareholder structure, and stock structure. They need to:

• be a domestic corporation formed in the United States
• Offer only one category of stock
• Total shareholders should not exceed 100
• The only acceptable shareholders are individuals, certain trusts, and estates
• Not have unacceptable shareholders who are non-resident aliens, partnerships or corporations
• Not be an inherently disqualified corporation – insurance companies, certain types of financial businesses, and international sales corporations are disqualified

If you are unsure about your business eligibility for S corporation status, it is always best to consult a professional.

How Does the S Corporation Compare to Other Business Structures?

S corporations are governed by Subchapter S of the Internal Revenue Code. Many business owners consider this business structure because of its pass-through taxation advantage that exempts corporations from paying federal corporate taxes.

Nevertheless, S corporations are profit-making companies and must pay built-in gains tax on assets acquired during the recognition period after electing S corp status. S corporations must also pay tax if passive investment income exceeds 25% of the entity's gross receipts.

Some business owners doubt whether establishing an S corporation is the right move. When setting up your business entity or considering changing your tax situation, compare the S corporation to other business structures to see which one best suits your needs, preferences, and goals.

S Corporation vs. C Corporation: Similarities

S corporations have many of the same obligations as most C corporations. They must comply with all state laws and maintain the same formal practices, including drafting and maintaining bylaws, working with a board of directors, holding regular shareholder meetings, and keeping minutes at all important meetings.

S corporations also enjoy the same liability protection as C corporations. This means that business owners and shareholders are not personally liable for debts or legal issues that the corporation may incur while doing business.

S Corporation vs. C Corporation: The Differences

When it comes to comparing C corporations vs. S corporations, the main difference between C corporations and S corporations is how each is taxed. While S corporations avoid most corporate taxes by passing them on to shareholders, C corporations are required to pay corporate taxes at a flat rate of 21% on all profits.

Dividends and profits after tax are distributed to shareholders, who pay taxes on those dividends. This structure is commonly referred to as ""double taxation."" While S corporations have more qualification restrictions, the avoidance of corporate taxes means that shareholders typically enjoy more of the company's profits.

S Corporation vs. LLC: Similarities

LLCs and S corporations have some similarities that appeal to many business owners. For example, both business structures limit the liabilities of owners, protecting them from personal responsibility for business debts, lawsuits and other liabilities. This is because, unlike sole proprietorships and general partnerships, S corporations and LLCs are separate legal entities from the owners.

LLCs and S corporations are also subject to pass-through taxation, although their policies differ. Neither business structure requires income taxes at the business or corporate level. While S corporations pass this responsibility to their shareholders, who report profits and losses, LLC owners report profits and losses on their personal income taxes. Note that LLCs can elect not to have pass-through taxation, while S corporations cannot because it is a defining characteristic of the business structure.

Profits and losses of an S Corp are earned and reported based on the ownership percentage (for example, a shareholder who owns 25% of the business is responsible for 25% of the profits and losses). In an LLC, profits and losses can be distributed among the owners in any way.

LLCs, like S corporations, also have ongoing maintenance obligations imposed by the state. These include annual fees, reporting requirements (annually and when certain changes occur in the business), and the requirement to obtain and maintain a registered agent. It is important to note that S corporations also have additional obligations, such as having a board of directors and holding shareholder meetings.

S Corporation vs. LLC: The Differences

Although S corps and LLCs have many similarities, they also have an extensive list of differences. For example, in exchange for taxation benefits, S corporations must adhere to ownership restrictions.

Number of Shareholders

An S corp can only have 100 shareholders (owners), and none of them can be non-U.S. citizens or residents. It cannot issue more than one class of stock or be owned by another corporation, LLC (unless it meets certain restrictions) or partnership.

However, LLCs can have as many owners as they want, and their shareholders can have citizenship or residency outside the U.S. They can also be owned by a corporation and issue multiple stock classes to shareholders.

Government

There are many differences in how S corporations and LLCs can be managed. By law, S corporations must be governed by a board of directors that elects officers to manage the daily affairs of the company.

LLC owners can choose to operate it themselves or have managers operate it. If they choose the latter option, the LLC usually ends up looking more like a corporation, since managers act like directors who are not involved in daily business affairs.

transfer of ownership

With regard to transferring ownership, S corporation shareholders can freely transfer ownership of their stock to anyone, provided that person meets citizenship and residency restrictions. If an LLC has more than one member, any member wishing to transfer ownership must usually obtain approval from the others, unless the operating agreement indicates otherwise.

Taxes

Unless the LLC owner chooses to have the entity taxed as a corporation, they cannot be considered employees of the business. Default pass-through taxation rules mandate that LLC owners claim profits and losses on their personal income taxes, which are usually subject to self-employment tax.

In an S corporation, owners  can be compensated with a salary (like an employee)  and must only pay FICA tax on their salary income. Corporate income is based on the percentage of ownership and can be considered unearned income. This means S corp owners can sometimes avoid unemployment taxes altogether.

Benefits and Drawbacks to an S Corporation

It's important for business owners to fully understand what they're getting into before choosing or changing a business structure. Here's a description of the benefits and drawbacks of S corporations to help you make an informed decision.

Benefits of Forming an S Corporation

Saving on corporate taxes with pass-through taxation is just one of the many benefits of forming an S corporation. Owners who elect this type of business entity also benefit from:

• Limited liability for everyone involved, including shareholders, directors, and officers
• Reducing self-employment taxes for business owners who become salaried employees
• Dividends are considered unearned income, which means they cannot be subject to self-employment tax
• Tax-free dividends, as long as they do not exceed the shareholder's stock basis
• Dividends in excess of the stock basis are taxed as capital gains at a lower rate than shareholder/employee income
• Asset transfer without tax consequences
• High level of credibility among potential investors and clients

Limitations of an S Corporation

No business structure is without its drawbacks, including S corporations. Business owners who choose this entity type face a few limitations:

• Limits on number of shareholders and citizenship/residency status
• Subject to fair compensation  rules to limit payroll tax avoidance 
• Allocation of profits and losses based on shareholder ownership percentage
• Noncompliance may lead to reclassification of S corp status
• Subject to additional fees and taxes depending on the state
• Limited to only one class of stock
• Investors may be hesitant due to limits on shareholder size

It is up to each S Corp owner to decide if these drawbacks are significant enough to consider using a different business structure.

Comparing the S Corporation to Other Business Entities

For those who are considering other types of entities, here's how S corporations stack up compared to other options you may be thinking about.

Steps to Establish an S Corporation

For those who want to do business as an S corporation, there are a few steps they need to take:

1. Incorporate your business with the state. Many people choose to start as an LLC or C Corp
2. Obtain a Federal Employer ID Number (FEIN)
3. Determine if your business meets the restrictions set by the IRS
4. Obtain Form 2553,  “Election by Small Business Corporation” from the IRS
5. Get all shareholders to sign the consent statement
6. Submit Form 2553  and all required tax and financial documents to the IRS 

As always, be sure to consult a professional to guide you through these steps and ensure you set up your business entity correctly.