Key Takeaways
- Pass-through taxation avoids corporate-level tax.
- Limited to 100 U.S. shareholder individuals or trusts.
- One class of stock; corporate formalities required.
What is S Corporation (S Subchapter)?
An S Corporation, or S corp, is a U.S. domestic corporation that elects special tax treatment under Subchapter S of the Internal Revenue Code, enabling it to operate as a pass-through entity. This election avoids the double taxation faced by a C corporation, by allowing income, losses, deductions, and credits to flow directly to shareholders’ personal tax returns.
Unlike a partnership, an S corp maintains a formal corporate structure but enjoys the tax advantages typically reserved for pass-through entities, making it a popular choice for small and closely held businesses.
Key Characteristics
S corporations combine the benefits of limited liability with pass-through taxation. Key features include:
- Shareholder Limit: Must have no more than 100 shareholders who are U.S. citizens or residents, trusts, or estates.
- Stock Structure: Only one class of stock is permitted, though voting rights may vary.
- Taxation: Income passes through to shareholders, avoiding federal corporate tax but requiring individual reporting via Schedule K-1.
- Compliance: Requires formalities like issuing stock, holding board meetings, and maintaining corporate records.
- Eligibility: Certain entities, including some banks and insurance companies, are ineligible for S status.
How It Works
To become an S corporation, a business first incorporates as a C corp and then files IRS Form 2553 to elect S status. Once approved, the company files an annual Form 1120-S that reports earnings but pays no federal income tax at the corporate level.
Shareholders receive Schedule K-1 forms reflecting their share of income or losses, which they report on personal tax returns. Unlike sole proprietors, shareholder-employees must take reasonable salaries subject to payroll taxes, with remaining profits distributed tax-free at the corporate level.
Examples and Use Cases
S corporations are ideal for small businesses seeking liability protection without the tax burden of a C corp. Examples include:
- Small family businesses: Often elect S status to combine protection with pass-through taxation.
- Professional firms: Such as accountants or consultants who want corporate structure and favorable tax treatment.
- Investor-owned companies: Where shareholders prefer earnings to flow through directly, similar to Delta or other publicly traded companies, but on a smaller scale.
Important Considerations
While S corporations avoid double taxation, they are subject to strict eligibility rules that must be monitored to maintain status. Exceeding shareholder limits or issuing multiple stock classes can cause involuntary revocation, reverting the company to C corporation taxation.
State tax treatment varies, so consult local regulations as some states impose additional taxes or fees on S corps. For managing business expenses and financing, you might find our guide on best business credit cards helpful to optimize cash flow and rewards.
Final Words
S corporations offer a valuable blend of liability protection and pass-through taxation, ideal for small, closely held businesses meeting specific IRS criteria. Evaluate your business structure and shareholder composition carefully to determine if electing S corp status aligns with your tax and operational goals.
Frequently Asked Questions
An S Corporation is a U.S. domestic corporation that elects special tax status under Subchapter S of the Internal Revenue Code, allowing income and losses to pass through directly to shareholders' personal tax returns. Unlike C Corporations, S Corps avoid double taxation by not paying federal corporate income tax.
To qualify as an S Corporation, the business must be a domestic corporation with no more than 100 shareholders who are U.S. citizens or residents, certain trusts, or estates. It can only have one class of stock and cannot be certain ineligible entities like banks or insurance companies.
S Corporations do not pay federal income tax at the corporate level. Instead, income, losses, deductions, and credits pass through to shareholders via Schedule K-1, who report them on their personal tax returns and pay taxes at individual rates.
The key advantage of an S Corporation is avoiding double taxation, as income is taxed only once at the shareholder level. Additionally, shareholders benefit from limited liability protection and the formal corporate structure.
Yes. Shareholders must be U.S. citizens or residents, certain types of trusts, or estates. Nonresident aliens, partnerships, corporations, and LLCs are not allowed as shareholders in an S Corporation.
Shareholder-employees must receive reasonable salaries subject to payroll taxes like Social Security and Medicare. Profits distributed beyond salaries are treated as nontaxable distributions and are not subject to self-employment taxes.
If an S Corporation exceeds the 100-shareholder limit, such as through a stock transfer, it loses its S Corporation status and reverts to being taxed as a C Corporation, which involves federal corporate income tax and potential double taxation.
First, you incorporate as a C Corporation by filing Articles of Incorporation with your state and completing corporate formalities like adopting bylaws and issuing stock. Then, you file Form 2553 with the IRS to elect S Corporation status.
