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.
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 is a corporation that is treated, for federal tax purposes, as a pass-through entity through an election made with the Internal Revenue Service (IRS). Electing “S corp” status could lead to important tax benefits.
A corporation is created by filing Articles of Incorporation with the Secretary of State or a similar government body. There is no requirement to notify your state of incorporation that your corporation will be an S corporation. This is a tax matter handled by the IRS.
The difference between a C corporation and an S corporation is in how they are taxed under income tax laws. The state corporation laws make no distinction. An S corporation issues stock and is governed as a corporation, with directors, officers, and shareholders who function in the same manner as their C corporation counterparts. The owners (the shareholders) have the same protection from liability as shareholders of a C corporation. An S corporation shareholder’s personal assets, such as personal bank accounts, cannot be seized to satisfy business liabilities.
However, like a sole proprietorship or a partnership, an S corporation passes through most of its income, losses, and deductions to the shareholders. Unlike a C corporation, there is no "double taxation", once at the corporate level and again on the individual shareholder level. Each shareholder is subject to his or her own individual tax rate on the income (or losses) passed through to him or her.
The S corporation derives its name from Subchapter S of the Internal Revenue Code 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 IRC – which is the part of the tax law that corporations will be taxed under unless they make the S corporation election.)
What are the requirements for an S corporation?
To qualify for S corporation status, your corporation must meet the following requirements:
- Be a domestic corporation
- 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, your corporation must submit Form 2553 Election by a Small Business Corporation signed by all the shareholders.
The advantages of an S corporation 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.
S corporation advantages include:
- 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 the Ongoing Corporation Requirements page of 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. (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’ 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.