Choosing the right business structure for your small business can often feel like a trade-off. Some entity types offer major fundraising advantages, like a C corporation, for which you can offer an unlimited number of shares, but which pay corporate taxes. Others come with more favorable tax treatment, like sole proprietorships and partnerships, which are only taxed once, at the owners’ personal income levels. An S corporation offers a middle path—boasting the legal advantages of a traditional corporation, alongside the tax benefits of other formats.
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 corps, LLCs, and LLPs, S corps are legal entities distinct from ownership, meaning shareholders’ liability for firm debts and legal damages is limited. Their personal assets cannot be reached by creditors or litigants.
What are the requirements of filing as an S corp?
To be an S corp, your small business first must 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. You’ll also have to appoint a board of directors, schedule annual board meetings, and write and file corporate bylaws.
To qualify for S corp status, the IRS says your small business must meet the following requirements:
- Location. The company must be 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).
- Share limits. The company may only issue shares to up to 100 shareholders, and shares may only be of one class of stock (common stock, which comes with voting rights but no dividend priority, as opposed to preferred stock, which comes with no voting rights but receives dividend payouts first).
- Shareholder restrictions. Shareholders may only include individuals, some trusts, and estates, but cannot include partnerships, LLCs, corporations, or non-resident aliens.
- Business restrictions. Some types of companies are not eligible 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).
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 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 taxes beyond income, and others are paid by shareholders beyond what they owe on personal income too.
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 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 taxes. 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 income tax. Some states and local authorities still impose tax liability on S corps. A small business in California or New York City would be subject to such tax. Regardless of your state tax obligations, your S corp will still have to file a Form 1120-S with the IRS to report profits, losses, and deductions.
Taxes the shareholders pay
The shareholders of your S corp small business may be liable to pay:
- 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.
- 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.
What are the advantages of filing as an S corp?
There are a number of advantages to electing to file for S corp status for your small business, mainly regarding liability protection and favorable tax treatment.
Liability protection. Shareholders in S corps are protected from liability directed at the company. If the company is sued or declares bankruptcy, for example, the personal assets of shareholders are out of reach to creditors and litigants.
Avoiding double taxation. S corps are pass-through entities—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.
Some 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 who are employed by the company are taxed on their salaries, and the company must pay that employee-shareholder reasonable compensation. (The S corp cannot avoid employment taxes by simply paying an employee-shareholder a nominal salary plus heftier dividends.)
What are the disadvantages of filing as an S corp?
There are also some disadvantages to electing to file for S corp status, including major limitations on shareholding and fundraising.
Limits on stock issuance. S corps can only issue to a maximum of 100 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.
Tax implications. 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 by issuing stock to a forbidden class of shareholders, 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.
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 whether an S corp is right for you.