Whether you are just starting your business or have been operating as a sole proprietorship or general partnership, you may be wondering about the advantages of incorporating your business as an S corporation. Many business owners assume it will be too costly or time-consuming — but neither is the case.
What is an S corporation?
A corporation is taxed for federal income tax purposes in one of two ways: as a “C corporation” or an “S corporation”.
An S corporation, or S corp, is a corporation that elects to be taxed as a pass-through entity with the Internal Revenue Service (IRS). This election can offer significant tax advantages by avoiding double taxation. To form a corporation you must file Articles of Incorporation with the Secretary of State or similar government body. However, S corporation is strictly a federal tax election, it’s not something you register with your state.
The difference between a C corporation and an S corporation lies in how they are taxed at the federal level. State corporate laws do not differentiate between the two. Both issue stock, are governed by directors and officers, and provide the same limited liability protection to shareholders as their C corporation counterparts. This means a shareholder’s personal assets – such as bank accounts – are protected from the corporation’s debts and legal obligations.
The primary tax distinction is this:
- A C corporation pays corporate income tax, and then shareholders pay personal income tax again on dividends received, resulting in double taxation.
- An S corporation avoids this by passing through most income, losses, deductions, and credits directly to shareholders, who report them on their personal tax returns at individual tax rates, similar to an LLC.
In essence, an S corp combines the legal protections of a corporation with the tax efficiency of a partnership or sole proprietorship.
IRS requirements for an S corp
To qualify for S corp status, your corporation must meet the following IRS requirements:
- Be a domestic corporation (incorporated within the U.S.).
- Have only allowable shareholders.
- Have no more than 100 shareholders.
- Have only one class of stock.
- Not be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations.
To become an S corporation, you must submit IRS Form 2553 Election by a Small Business Corporation signed by all the shareholders.
Related: What is an S corp?
Why is it called an S corporation?
The S corporation derives its name from Subchapter S of the Internal Revenue Code (IRC), which provides corporations a "tax election" option — a choice on how they want to be taxed. Under Subchapter S, a company elects to pass all its profits to its shareholders directly. (The C corporation gets its name from Subchapter C of the IRS, which is the part of the tax law that corporations will be taxed under unless they make the S corporation election.)
S corporation advantages: Tax benefits and more
The advantages of an S corporation can often outweigh any perceived disadvantages. The S corporation structure can be especially beneficial when it comes time to transfer ownership or discontinue the business. These advantages are typically unavailable to sole proprietorships and general partnerships.
Protected assets
An S corporation protects the personal assets of its shareholders. Absent an express personal guarantee, a shareholder is not personally responsible for the business debts and liabilities. Creditors cannot pursue the personal assets (house, bank accounts, etc.) of the shareholders to pay business debts. In a sole proprietorship or general partnership, owners and the business are legally considered the same, leaving personal assets vulnerable.
Pass-through taxation
An S corporation does not pay federal taxes at the corporate level. (Most — but not all — states follow the federal rules. View our state guides to see if your state recognizes the federal S corporation election.) Any business income or loss is "passed through" to shareholders who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns. This can be extremely helpful in the startup phase of a new business.
Note: A corporation that does not elect S corporation status and accumulates passive income is at risk of being classified as a personal holding company.
Tax-favorable characterization of income
S corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation. A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.
Straightforward transfer of ownership
Interests in an S corporation can be freely transferred without triggering adverse tax consequences. The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.
Cash method of accounting
C Corporations must use the accrual method of accounting unless they are considered to be “small corporations” and meet the IRS’s gross receipts test. S corporations, however, usually don't have to use the accrual method unless they have inventory.
Heightened credibility
Operating as an S corporation (rather than a sole proprietorship or partnership) may help a new business establish credibility with potential customers, employees, vendors, and partners because they see the owners have made a formal commitment to their business.