S Corporation

What Is an S Corporation?

An S corporation is a type of corporate business entity that allows for pass-through taxation. Instead of paying corporate taxes, the S corporation definition of a pass-through entity means the business passes its income, credits, and losses to its shareholders, who then report those corporate finances on their individual income taxes.

This business structure is in stark contrast to the C corporation, which requires corporate tax filings.

What Qualifies a Business to Be an S Corporation?

Businesses looking to be designated as an S corporation for tax purposes have a list of criteria to meet in regard to business type, size, shareholder makeup, and stock makeup. They need to:

• Be a domestic corporation formed in the United States
• Offer only one class of stock
• Have no more than 100 total shareholders
• Have only allowable shareholders who are individuals, certain trusts, and estates
• Not have unallowable shareholders who are non-resident aliens, partnerships, or corporations
• Not be an inherently ineligible corporation—insurance companies, certain types of financial businesses, and international sales corporations are ineligible

If you’re unsure about your business eligibility for S corporation status, it's always best to consult a professional.

How Does an S Corporation Compare to Other Business Structures?

S corporations are governed by Subchapter S of the Internal Revenue Code. Many business owners consider this business structure because of its pass-through taxation benefit, which allows corporations to forgo paying federal corporate taxes.

Still, S corporations are for-profit companies and must pay the built-in gains tax on assets received during the recognition period that follows the election of S corp status. S corporations also owe taxes if passive investment income exceeds 25% of the entity’s gross receipts.

Some business owners wonder whether setting up an S corporation is the right move. When setting up your business entity or considering altering your tax status, compare the S corporation to other business structures to see which one best suits your needs, preferences, and goals.

S Corporation vs. C Corporation: Similarities

S corporations hold many of the same obligations as most C corporations. They must abide by all state laws and maintain the same formal practices, which include drafting and maintaining bylaws, operating with a board of directors, conducting regular shareholder meetings, and keeping minutes at all important meetings.

S corporations also get the same liability protection as C corporations. This means that the business owners and shareholders are not personally liable for the debts or legal issues the corporation may incur while conducting business.

S Corporation vs. C Corporation: Differences

When it comes to a C corporation vs. S corporation comparison, the primary difference between a C corporation and an S corporation is how each is taxed. While S corporations avoid most corporate taxes by passing them on to shareholders, C corporations must pay corporate taxes on all profits at a flat rate of 21%.

After-tax dividends and profits are then distributed to shareholders, who pay taxes on those dividends. This structure is commonly known as “double taxation.” While S corporations do have more qualification restrictions, avoiding corporate taxes means shareholders typically enjoy more of the company’s profits.

S Corporation vs. LLC: Similarities

LLCs and S corporations have some similarities that appeal to many business owners. For instance, both business structures limit the liabilities of the owners, shielding them from personal responsibility for business debts, lawsuits, and other liabilities. This is because, unlike sole proprietorships and general partnerships, S corporations and LLCs are legal entities separate from owners.

LLCs and S corporations are also subject to pass-through taxation, though their policies are different. Neither business structure requires income taxes at the business or corporate level. While S corporations pass this responsibility on to their shareholders, who report profits and losses, owners of LLCsreport profits and losses on their personal income taxes. Note that LLCs can elect not to have pass-through taxation, while S corporations cannot since it’s the defining feature of the business structure.

S corp profits and losses are received and reported based on ownership percentage (e.g., a shareholder owning 25% of the business is responsible for 25% of the profits and losses). In an LLC, profits and losses may be distributed among owners in any way.

LLCs, much like S corporations, also have ongoing maintenance obligations placed by the state. These include annual fees, reporting requirements (both annually and when certain changes occur in the business), and the need to obtain and maintain a registered agent. It’s important to note that S corporations do have additional obligations, such as having a board of directors and conducting shareholder meetings.

S Corporations vs. LLCs: Differences

Though S corps and LLCs have many similarities, there’s also an extensive list of differences. For example, in exchange for taxation benefits, S corporations must abide by ownership restrictions.

Number of Shareholders

An S corp can only have 100 shareholders (owners), and none of them can be non-U.S. citizens or residents. It also can’t issue more than one class of stock or be owned by another corporation, LLC (unless it meets certain restrictions), or partnership.

LLCs, however, can have as many owners as desired and can have shareholders with citizenship or residence outside the U.S. They can also be owned by a corporation and can issue multiple stock classes to shareholders.

Governance

There are huge differences in how S corporations and LLCs can be managed. According to law, S corps must be governed by a board of directors that elects officers to manage the company's daily affairs.

Owners of an LLC can choose to govern it themselves or have managers do it. If they choose the latter, the LLC usually ends up looking much like a corporation, as the managers function more like directors who aren’t involved in daily business affairs.

Transferring Ownership

Regarding transferring ownership, S corporation shareholders can freely transfer the ownership of their stock to anyone they choose, as long as that person meets citizenship and residency restrictions. If an LLC has more than one member, any member who wants to transfer ownership must usually get approval from the others unless the operating agreement indicates otherwise.

Taxes

Unless the owners of an LLC choose to have the entity taxed as a corporation, they can’t be treated as employees of the business. Default pass-through taxation rules mandate that LLC owners claim profits and losses on their personal income taxes, which are usually subject to a self-employment tax.

In an S corporation, owners can be compensated with a salary (just like an employee) and only pay FICA taxes on their salaried income. The corporate earnings passed through are based on the percentage of ownership and can be considered unearned income. This means S corp owners can sometimes avoid the unemployment tax altogether.

Benefits and Drawbacks for S Corporations

It's important for business owners to fully understand what they’re getting into before choosing or changing a business structure. Here‘s a breakdown of the benefits and drawbacks of S corporations to help you make an informed decision.

Benefits of Creating an S Corporation

Saving on corporate taxes with pass-through taxation is just one of the many benefits of creating an S corporation. Owners electing this type of business entity also enjoy:

• Limited liability for everyone involved, including shareholders, directors, and officers
• Lower self-employment taxes for business owners who become salaried employees
• Dividends considered unearned income, meaning they may not be subject to self-employment taxes
• Tax-free dividends as long as the shareholder’s stock basis isn’t exceeded
• Dividends exceeding the stock basis are taxed as capital gains at a lower rate than the shareholder/employee’s income
• Asset transfers without tax consequences
• Higher level of credibility with potential investors and customers

Limitations of an S Corporation

No business structure is without its drawbacks, including S corporations. Business owners choosing this entity type do face a few limitations:

• Limits on the number and citizenship/residency status of shareholders
• Subject to reasonable compensation rules to limit payroll tax avoidance
• Profits and losses allocated based on shareholder ownership percentages
• Noncompliance can lead to S corp status reclassification
• Subject to additional fees and taxes, depending on the state
• Limited to just one class of stock
• Investors may be hesitant due to shareholder size limitations

It’s up to the owners of each S corp to decide whether these drawbacks are enough to consider using a different business structure.

Comparing the S Corporation to Other Business Entities

For those considering other entity types, here’s how S corporations stack up against other choices you may be thinking about.

Steps to Set Up an S Corporation

There are a few steps required for those who wish to do business as an S corporation:

1. Incorporate your business with the state. Many choose to start out as an LLC or C corp
2. Get a Federal Employer ID Number (FEIN)
3. Determine whether your business meets the restrictions set forth by the IRS
4. Obtain Form 2553 from the IRS, “Election by a Small Business Corporation”
5. Have all shareholders sign the consent statement
6. Submit Form 2553 and all required tax and financial documentation to the IRS

As always, make sure to consult a professional to help guide you through these steps and ensure you set up your business entity correctly.