An S corporation is a corporation that has elected to be taxed for federal income purposes under Subchapter S of the Internal Revenue Code instead of Subchapter C.
Defining S corporations
An S corp is a standard corporation that elects pass-through taxation with the Internal Revenue Service (IRS). An IRS tax election is a selection made by a taxpayer, in this case the business entity, regarding how it will be treated under federal tax law. After incorporating with the state, a corporation must file Form 2553 (Election by a Small Business Corporation) with the IRS in order to receive S corp status.
An S corp election allows a corporation to pass its income, losses, deductions, and credits through to its shareholders. This allows an S corp to avoid the double taxation issues that standard corporations have.
The S corporation shareholders pay income taxes on the business’s income on their personal income tax return at their individual income tax rate. The S corporation itself does not pay federal corporate income taxes.
An S corporation operates in the same manner as a standard corporation (also known as a C corporation). Since the state corporation laws make no distinction between S corps and C corps, S corps must comply with all requirements of the corporation law under which they have been formed.
Difference between an S corp and a C corp
As previously indicated, “S corp” and “C corp” are IRS tax designations. The difference between an S corporation and a C corporation is in how they pay income taxes. An S corporation pays taxes under Subchapter S of the Internal Revenue Code, which is why it is called an S corporation. A C corporation pays taxes under Subchapter C (hence the name C corporation).
All corporations are taxed for federal income tax purposes as a C corporation — unless they qualify for, and elect to be taxed as, an S corporation.
An S corporation does not pay federal corporate income taxes. Its shareholder or shareholders pay the tax on the corporation’s income. A C corporation is subject to federal corporate income tax. By default, all corporations are taxed under Subchapter C. A C corp pays tax on its income at the entity level. When profits are distributed to shareholders as dividends, those are also taxed again at the individual level, resulting in double taxation. In order to be taxed under Subchapter S, the corporation must file an election form with the IRS.
There are additional differences regarding stock and ownership and stock. According to IRS rules, an S corp can only issue one class of stock. There are also restrictions on who can be an S corporation shareholder. S corp shareholders can be individuals, certain trusts, and estates. However, an S corp shareholder may not be a partnership, corporation, or a nonresident alien for tax purposes. An S corp also cannot have more than 100 shareholders.
Related: S corp vs. C corp: Key differences
How is an S Corp taxed?
If you elect S corp status for your corporation, the business’ income would not be subject to federal corporate income tax. The S corporation’s income “passes through” to the shareholders. The shareholders pay income taxes on their share of the corporation’s income at their individual income tax rates.
Most state tax departments recognize S corps the same way the IRS does and tax shareholders accordingly. But not all states do. It is best to consult with a tax advisor on how S corps are taxed in the state where your corporation is incorporated and in any other state where it does business.
S corp pros and cons
S corp owners frequently list these as the main benefits of an S corp:
- Limited liability protection. The owner’s personal assets are protected against losses, debt, and claims against the company. This is an advantage over sole proprietorships and partnerships.
- Single level of taxation. This is considered the main advantage of an S corp over a C corp. In an S corp, income taxes are not paid at the corporate level. In a C corp, the corporation pays corporate income taxes and any distributions to shareholders are taxed again at the shareholder level. Therefore, a C corporation’s income is subject to double taxation.
- An S corp election may lower your employment taxes. Reducing your overall employment tax liability is possible because you can be both the owner and an employee of your corporation. Shareholders can be employees of the business and can be paid salaries as employees. Employment taxes must be paid on the amounts received as salary. However, shareholders can also receive dividends from the corporation on which employment taxes are not paid. This is an advantage S corps have over sole proprietorships and partnerships, whose owners are not considered employees.
- S corps may have reduced taxable gains. If you choose to sell your business, your S corp could have reduced taxable gains.
- S corps can write off startup losses. An S corp can write off many of the expenses and losses incurred during the early years of starting the business. These are offset against personal income. Shareholders in C corporations cannot use losses to offset profits.
- Cash method of accounting. S corporations can choose either the cash or accrual method of accounting. (However, if they maintain inventory, they must use the accrual method.) C corporations generally cannot use the cash method.
Here are some possible S corp disadvantages:
- Complexity is a key disadvantage. Corporations, whether it is an S corp or C corp, are more challenging for small businesses to set up and administer than doing business as a sole proprietorship, partnership, or LLC. And because an S corp is a corporation, it must adhere to the strict filing and operational processes of a corporation. Incorporating can also be costly. To maintain compliance with tax and legal requirements, many S corp business owners outsource to tax and legal professionals.
- Limit on number and citizenship of shareholders. S corporations may only have up to 100 shareholders, and individual shareholders must be a U.S. citizen or resident alien.
- Calendar year. An S corporation must adopt a calendar year as its tax year unless it can establish a business purpose for having a fiscal year.
- One class of stock. An S corporation can only have one class of stock, which can impair the corporation's ability to raise capital. (Note: Non-voting stock is not considered a “separate class” for this purpose.)
- Taxable fringe benefits. Most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2 percent of the corporation. This is a disadvantage of S corp taxation versus C corp taxation.
Related: S corporation advantages and disadvantages
What are the requirements for an S corp?
Not all corporations can be taxed as an S corp. To qualify for S corp status, your corporation must meet the following criteria:
- Be a domestic corporation
- Have only allowable shareholders. These may be individuals, certain trusts, and estates. Not allowed are partnerships, LLCs, corporations, or non-resident alien shareholders.
- Shareholders are limited in number of up to 100
- Have only one class of stock. (There can be classes with different voting rights but not different economic rights, such as a preferred right to dividends or distributions.)
- Certain corporations may be barred from becoming an S corp, including certain financial institutions, insurance companies, and domestic international sales corporations
- In order to elect S corporation tax status, all shareholders must approve the election
How do I form an S corp?
You technically don’t form an S corp or a C corp. You form a corporation. Incorporation documents, typically called the Articles of Incorporation or Certificate of Incorporation, must be filed with the appropriate state agency and the necessary state filing fees paid.
While specific requirements can vary by state, here are the general steps for setting up an S corporation.
Step 1: Choose a corporate name
Each state has different rules on how corporations can be named. Generally, the requirements are that -
- The name must end with “Corporation”, “Inc.”, or other state-approved term or abbreviation
- The name cannot be too similar to the name of another registered business entity on the Secretary of States records
Certain words (ex. “Bank”, “Insurance”) may require prior approval from a state department or agency.
Step 2: Decide on share structure
A corporation’s formation document will need to include the authorized number of shares of stock. An S corp can have up to 100 shareholders, and there can only be one class of stock.
Step 3: Obtain a registered agent in the state
A registered agent is a person or company that a business appoints to receive service of process and other important legal and tax documents. You will need to obtain a registered agent in your state of incorporation and any additional states the S corporation will be registering to do business.
Step 4: File Articles of Incorporation
Articles of Incorporation is the formation document used to officially create a corporation in a state. This document is filed with the state office handling business entity filings. In many states, incorporation filings are handled by the Secretary of State’s office. The existence of the corporation begins when the state accepts the Articles of Incorporation, unless the document includes a delayed effective date.
Some states may require initial reports/statements to be filed and fees to be paid within the months following incorporation. Your online incorporation specialist or registered agent will let you know if your state has this requirement.
Related: What are Articles of Incorporation?
Step 5: Hold an organizational meeting, prepare bylaws, issue stock
After forming the corporation, the corporation must hold an initial meeting to adopt by-laws, elect directors, and complete other responsibilities. Here is an example of tasks that may be required by the state of incorporation:
- Appointing directors (if initial directors were not named in the Articles of Incorporation)
- Adopting corporate bylaws (similar to an operating agreement for an LLC)
- Electing officers
- Issuing stock
- Selecting a corporate bank
- Setting the organization’s fiscal year
- Setting up a corporate records book
Step 6: Get an EIN
A federal employer identification number, or EIN, is a business identification number issued by the IRS. All corporations are required by federal tax law to obtain an EIN.
An EIN is used for tax filings and for other important business activities, such as opening a business bank account, setting up vendor accounts, and obtaining a loan.
Related: What is an EIN?
Step 7: Make a tax election with the IRS
If the corporation meets IRS eligibility requirements, it can file Form 2553 (Election by a Small Business Corporation) in order to be taxed as an S corporation.
Note: Most states will automatically recognize a corporation's federal S corp election for state tax purposes. However, a few states, such as New York, require a separate state S-tax election.
Step 8: Comply with other state tax and regulatory requirements
After incorporation, you may need to complete additional compliance steps in order to legally operate in the state. Here are sample requirements:
- State business tax registration
- Employer registrations
- General business license
- Professional and occupational licenses
- Local permits and zoning approvals
- “Doing business as” name filing
Step 9: Register to do business in other states (if necessary)
If an S corporation intends to do business in other states, it will need to register in each of those states. This process is known as “foreign qualification”. (“Foreign” refers to a state or jurisdiction other than your incorporation state.)
Foreign qualification generally requires filing an application for authority with the Secretary of State. A Certificate of Good Standing from your incorporation state is often required as well. The S corp will also have to appoint and maintain a registered agent and file an annual report in each additional state.
Many factors are used to determine whether a company is transacting business in a state, and therefore needs to foreign qualify. Some of the common criteria include whether your company -
- has a physical presence in the state
- has employees in the state
- accepts orders in the state
Note that different states have different criteria. To determine whether your S corp needs to foreign qualify in a certain state, it is best to seek the advice of an attorney.
Related: Doing business in another state (Foreign qualification)
Maintaining your corporate status under the state corporation law
An S corp must comply with the corporation law of its state of incorporation. And although state laws differ, in general, in order to maintain its good standing in the state, an S corp will have to continually maintain a registered agent, file annual reports, and pay franchise taxes.
It’s important to be aware of the due dates for annual (or biennial) reports. These vary by state. Some states connect due dates to the anniversary of the corporation’s formation and some have a fixed date.
The S corporation will need to observe corporate formalities, such as -
- Holding a shareholders’ meeting every year
- Keeping corporate minutes (in a corporate record book) and allowing shareholders to vote on major corporate decisions
- Maintaining bylaws
- Keeping a record of all stock transfers
- Keeping detailed financial records
As with any business, the S corporation will also have to keep any required licenses and permits up to date.
Maintaining your S corp tax status with the IRS
An S election is effective until it is voluntarily terminated by the corporation, or it is revoked by the IRS.
In order to continue being taxed as an S corporation, you must comply with the requirements of Subchapter S of the Internal Revenue Code. If you add an ineligible shareholder (such as a citizen of a foreign country), have more than 100 shareholders, or add a class of preferred stock, your corporation’s S election will be revoked by the IRS. In addition, the corporation will generally be prohibited from making a new election for five years.
Therefore, it’s important to be aware of the requirements to ensure you don’t unintentionally lose your S corporation tax status.
S corp state guides
Corporation requirements can vary by state. Select your state to view detailed information.
