S corporations are a great business structure for small and medium-sized companies, as they offer limited liability and avoid double taxation.
But getting this tax status isn’t easy. Misunderstanding or missing a single requirement could result in potential penalties, or even revoking your S corp status.
Ahead, you’ll learn the essential criteria and steps to follow to leverage S corp status, without stumbling into common pitfalls.
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What is an S corporation (S corp)?
An S corporation, or S corp, is a modified form of corporation under Subchapter S of Chapter 1 of the US Internal Revenue Code, which is not subject to federal corporate tax. It is also a tax status for other business entities; for example, limited liability companies may elect to be taxed as S corps, even though their entity type is LLC.
Like a sole proprietorship or partnership, an S corp is chiefly defined by its pass-through tax status—it passes corporate income, losses, deductions, and credits through to shareholders for purposes of federal income tax.
Like C corporations (C corps), limited liability companies (LLCs), and limited liability partnerships (LLPs), S corps are legal entities distinct from ownership, meaning shareholders’ personal liability for business debt and legal damages is limited. In other words, their personal assets cannot be reached by creditors or litigants.
What are the filing requirements for an S corp?
Not every corporation can receive S corp status. The IRS has strict requirements for S corps. They’re limited to smaller businesses located in the US. To become an S corporation, you must meet certain criteria and make an election to be taxed under Subchapter S of the Internal Revenue Code.
To start an S corp, your small business must first be established as a corporation by filing articles of incorporation with the appropriate state governing authority, and pay the applicable filing fee.
Once incorporation is completed, shareholders must sign Form 2553 (Election by a Small Business Corporation), which is filed with the Internal Revenue Service (IRS). You’ll also have to appoint a board of directors, schedule annual board meetings, and write and file corporate bylaws (similar to an operating agreement for LLCs).
Here are the requirements:
Be a domestic corporation
An S corporation must be a domestic corporation, domiciled in the United States. It must be incorporated in one of the 50 states, Washington, DC, or one of the five inhabited US territories.
Have eligible shareholders
Only living persons can be shareholders in an S corporation. This means that other entities, such as corporations or partnerships, generally cannot be shareholders in an S corporation.
Not all trusts are eligible to be shareholders of an S corporation. The following types of trusts can be:
- Grantor trust
- Testamentary trusts
- Qualified Subchapter S trust (QSST)
- Electing small business trust (ESBT)
Some tax-exempt organizations, like a nonprofit organization, are allowed to be shareholders of an S corporation.
Only US citizens or resident aliens can be shareholders of an S corporation. Non-resident aliens are not eligible.
Limit on shareholders
The corporation cannot have more than 100 shareholders. However, members of a family (and their estates) can be treated as a single shareholder for this purpose.
One class of stock
An S corporation can only have one class of stock. All shares of an S corporation must have the same rights to distributions and liquidation proceeds. Voting rights can differ, but distribution rights can’t.
No more than 25% passive income
If an S corporation has accumulated earnings and profits and earns more than 25% of its gross receipts from passive sources for three consecutive years, it can lose its S corp status. Passive income can be from things like certain rents, royalties, annuities, interest, and stock sales.
Some types of companies are ineligible corporations for S corp status, such as insurance companies, some financial institutions, or domestic international sales corporations (exporters of US goods that receive special tax treatment).
A corporation operating within a state’s jurisdiction has its own rules and requirements. When you’re looking for S corporation status, you have to think about not only the federal requirements but also the state requirements where your company is incorporated as well as in other states where you do business.
For example, some states automatically recognize the federal S corporation election, others do not. In states that do not automatically recognize the federal election, like Arkansas or Louisiana, a separate state-specific election might be required. You may be subject to additional taxes too, depending on the state you operate in.
What taxes do S corps pay?
S corps are different from C corps in that they are not subject to double taxation—that is, they pass corporate income tax liability through to shareholders, which are then taxed at their personal income levels, instead of being taxed on corporate income directly by the IRS.
Still, S corps are obligated to pay certain taxes beyond corporate income tax.
Taxes S corps must pay
Your S corp small business may be liable to pay:
- Estimated tax: If the firm expects to owe tax of $500 or more when its income tax return is filed. Use IRS Form 1120-W if this applies to your S corp.
- Employment tax: Social Security and Medicare taxes and federal unemployment (FUTA) tax. Use Form 941 to report your S corp’s Social Security and Medicare tax withheld from employees’ paychecks; use Form 940 to report your S corp’s FUTA tax.
- Excise tax: These are taxes imposed on specific goods, services, and business activities—sports betting, indoor tanning services, heavy highway vehicle use, and more. Each excise tax will have its own form to file with the IRS.
- Income tax: Not all S corps are completely exempt from paying corporate income tax. Some states and local authorities still impose tax liability on S corps. For instance, S corp businesses in California or New York City would be subject to a tax on net income. Regardless of your state tax obligations, your S corp will still have to file a Form 1120-S with the IRS to report net profits, losses, and deductions.
Taxes shareholders pay
The shareholders of your S corp small business may be liable to pay:
- Estimated tax: S corp shareholders must make estimated tax payments if they expect to owe $1,000 or more in tax when their personal tax returns are filed. They may use Form 1040-ES to make the applicable reports to the IRS.
- Income tax: Shareholders will be subject to federal income tax, in addition to state income tax obligations. They may use forms 1040 or 1040-SR to file income tax returns with the IRS.
Advantages of filing as an S corp
There are a number of advantages to electing to file for S corporation status for your small business, mainly regarding liability protection and favorable tax treatment.
Shareholders in S corps enjoy limited liability protection. If the company is sued or declares bankruptcy, for example, the personal assets of shareholders are out of reach to creditors and litigants.
Avoid double taxation
S corps are pass-through entities—that is, corporate profits and losses “pass through” to shareholders, who are then taxed on that income at their personal income levels. C corps, conversely, are taxed twice: once on corporate taxable income, and again at the shareholder level. Thus, filing as an S corp may lower a company’s overall tax burden.
Tax savings for owners
S corp shareholders do not pay self-employment taxes on distributions from business profits, as they would if they were taxed as a sole proprietor, general partnership, or LLC. Owners and shareholders employed by the company are taxed on their salaries, and the company must pay that employee-shareholder reasonable compensation. Note that owners must pay themselves a “reasonable salary,” as defined by the IRS. An S corp cannot avoid employment taxes simply by paying the owner a nominal salary plus heftier dividends.
Unsure if an S corp is right for you? Read and compare to other types of corporations:
- LLC vs. S Corp: Choosing the Best Option for You
- Sole Proprietorship vs. S Corp: A Guide to the Differences
- S Corp vs. C Corp: Benefits and Comparison
Disadvantages of filing as an S corp
There are also some disadvantages to electing to file for S corporation status, including major limitations on shareholding and fundraising.
Limits on stock issuance
S corps can only issue shares to a maximum of 100 allowable shareholders, which puts a cap on fundraising goals. Stocks can only be sold to US citizens or resident aliens, and cannot go to corporate entities.
Corporation shareholders and/or employees who hold more than 2% of the S corp’s shares may not receive corporate health benefits as a tax-free distribution. And since taxes are paid at shareholders’ personal tax rates, high-income shareholders may pay more taxes on dividends.
Consequences for not following rules
If an S corp’s tax status is compromised, the IRS can revoke S corp status and charge back taxes for the prior three years and impose a five-year waiting period to regain S corp status. Violations that could result in revocation of S corporation status include issuing stock to a forbidden class, such as non-resident alien shareholders, or passive income exceeding 25% of gross receipts for three consecutive tax years.
In many ways, S corps offer a compromise between the fundraising advantages and liability protection of a traditional C corp, and the tax-savings upside of a pass-through business entity.
Though ideal for younger and leaner startups, for which every penny counts, companies with big aspirations may feel hamstrung by limits on stock issuance. Review, and possibly modify, your small business’s long-term growth plan before deciding what type of corporation is right for you.