Everything *Most* People Need to Know About S Corporations
Photo by Annie Spratt on Unsplash
Author: Ty Leitow
Last updated: December 27, 2024
1. What is a S Corporation?
Every business has a certain business structure that determines how a company is taxed, and how profits, losses, expenses and liability affect its owners. A S corporation is a type of business structure that allows the company to pass corporate income, losses, deductions, and credits through to their owners (the company’s shareholders) for federal income tax purposes.[1] Shareholders of S corporations report the “flow-through” of business income and losses on the shareholder’s personal tax returns. This pass-through taxation is the primary advantage S corporations have over C corporations. However, there is a trade-off, as S corporations have more restrictions on who may own shares of a S corporation, and how many shareholders there may be, which will be discussed below.
S corporations get their name from the Internal Revenue Code, and the subchapter they are taxed under, which is Subchapter S. S Corporations are the most popular business structure in the United States, especially for small businesses. The IRS estimates that there are over 5 million S corporations in the US, which is roughly 3 times the number of C corporations.[2] Technically speaking, a corporation or a limited liability company (“LLC”) may elect S corporation tax status if it meets the IRS’ ownership requirements.
2. What are the Benefits of being a S Corporation?
Pass-Through Entity. The primary benefit of the S corporation is that it is a “pass-through” entity. That means the S corporation passes the income, losses, deductions, and credits directly to its shareholders, without paying any federal tax at the corporate level. Pass through taxation means corporate profits are only taxed once at the individual shareholder level.
Compared to C corporations, S corporations’ pass through taxation is generally viewed as favorable. C corporations’ profits are taxed twice: once at the corporate level at the applicable corporate tax rate, and a second time when profits are distributed to its shareholders as dividends at the applicable individual shareholder tax rate. This is known as double taxation and it’s one of the primary drawbacks to a C corporation’s business structure.
Dividends. S corporation shareholders can be employees of the company where they may earn a salary and receive corporate dividends. Dividends issued to S corporation shareholders may be tax free if the distribution doesn’t exceed a shareholder’s tax basis (dividends in excess of a shareholder’s stock basis are taxed as capital gains).[3]
Limitation of Liability. S corporations limit the personal liability of its directors, officers, employees and shareholders. Generally, business debts and liabilities of a S corporation cannot become a personal obligation of any individual director, officer, employee, or shareholder. Said differently, generally, as long as corporate formalities are followed, the owners of S corporations will not be held responsible for the debts or liabilities of the business. S corporations, C corporations and LLCs provide this benefit of limitation of liability.
Perpetual Life. S corporations are separate legal entities from the shareholders, and this allows a S corporation to continue perpetually, beyond the life of the owners. A S corporation can theoretically exist forever.
Shareholder-Employees. Shareholders of S corporations may also be employees of the company. Typically, this can reduce tax liabilities, especially when compared to a C corporation, where there are requirements to keep owners and management legally separated.
Self-Employment Tax. Generally speaking, individuals who earn money from self-employment are required to pay a self-employment tax.[4] The self-employment tax rate is currently 15.3%, which consists of 12.4% for social security and 2.9% for Medicare. For W2 employees, they pay the same taxes which are designated on a paystub as FICA and MEDFICA, with one key difference: the employer pays half (7.65%) and the employee pays the other half (7.65%). FICA and MEDFICA are generally referred to as payroll taxes.
When owner-employees of a S corporation pay themselves a salary, that salary is subject to payroll taxes. When additional profits are distributed to owner-employees as dividends, those dividends are not subject to payroll taxes or self-employment taxes. This usually represents favorable tax treatment when compared to other pass-through business structures like general partnerships and limited liability companies (“LLCs”). For example, in most LLCs, owners are subject to self-employment taxes on all net earnings from the business.
3. What are the Drawbacks of being a S Corporation?
Ownership Restrictions. All S corporation shareholders must be US citizens, legal residents or specific types of trusts or special entities.[5] Additionally, S corporations may only issue one class of common stock and are only allowed to have a maximum of 100 shareholders. Collectively, these ownership restrictions are the primary drawback when compared to a C corporation.
IRS Scrutiny. The IRS will more closely analyze how S corporations pay their employees because owner-employees can disguise salaries as distributions (dividends) to avoid paying payroll taxes. Generally, a S corporation is required to pay reasonable salaries to owner-employees before any dividends are paid.[6]
Capital Investment Limitations. The restrictions on the number of and type of shareholders may limit the capital investment into the company, especially from venture capital or institutional investors. Businesses that hope to experience high growth, and/or require substantial capital investment from a diverse set of investors, should carefully consider whether the S corporation is the right business structure.
For example, if part of your business plan involves some great new idea, that will have you creating a pitch deck and courting venture capital and investment banks for large sums of money, a S corporation may not be the right choice. Instead, a C corporation often makes more sense in those situations. S Corporations are better suited for smaller and medium-sized businesses who have some complexity and would benefit from a more hierarchal management structure, similar to a C corporation, but would also benefit from the pass-through taxation.
Costly to Start. Compared to other business structures, a S corporation is more expensive and complicated to start. An S corporation may be started as a corporation or a LLC. In both cases, there is an additional IRS filing step that is required before your business will be recognized as a S corporation (discussed in more detail below). The filing fees for the articles of incorporation (for a corporation) or the articles of organization (for a LLC) for a S corporation can be expensive, depending on the state you’re filing in. Additionally, simply drafting the articles of incorporation or articles of organization (as well as the bylaws for a corporation or operating agreement for a LLC) can be complicated, often requiring the assistance of an attorney, which adds to the overall start-up costs.
Corporate Formalities. A S corporation is required to hold shareholder (corporation) / member (LLC) meetings, board of directors’ meetings, and to maintain detailed and accurate minutes of each meeting. Additionally, a S corporation must keep voting records of the company’s directors (or managers, in the case of some LLCs), and records of the owners’ names and ownership percentages. Collectively, these activities are known as “corporate formalities”. Generally, corporate formalities must be performed, or the owners, directors and officers risk losing the limited liability protection discussed above.
4. How to Start a S Corporation.
Corporation or LLC. Generally speaking, starting a S corporation requires the same steps as starting a C corporation or a LLC. For a corporation, this includes properly selecting a company name, filing the articles of incorporation and determining a registered agent, obtaining a tax EIN, drafting the company bylaws, issuing shares, and recognizing corporate formalities. For a LLC, this includes properly selecting a company name, filing the articles of organization and determining a registered agent, obtaining a tax EIN, drafting the company operating agreement, issuing membership certificates, and holding member/manager meetings.
Electing S Corporation Status with the IRS. To be treated as a S corporation, you need to elect to be recognized as a S corporation by the IRS. By default, the IRS recognizes all corporations as C corporations for tax purposes. For LLCs, by default, the IRS recognizes single-member LLCs as sole proprietorships and multi-member LLCs as partnerships for tax purposes. If, after careful consideration and consultation, you determine that electing to be taxed as a S corporation makes the most sense, you first need to ensure that your corporation or LLC meets the ownership requirements of a S corporation.[7] Provided that you meet the IRS requirements, you can elect S corporation tax status by filing IRS Form 2553.
Guidance from a Professional. Generally, starting a S corporation will require the help of an accountant, attorney, or other business professional with S corporation experience. Compared to a general partnership or LLC, S corporations are more complex to create and manage.
[1] https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
[2] https://s-corp.org/our-history/#:~:text=Over%20a%20half%20century%20later,the%20number%20of%20C%20corporations.
[3] https://www.investopedia.com/terms/s/subchapters.asp ; https://www.thetaxadviser.com/issues/2014/jan/nitti-jan2014.html
[4] https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes
[5] https://tax.thomsonreuters.com/blog/s-corp-vs-c-corp-vs-llc-whats-the-difference-and-which-one-is-better-for-your-business/#what-is-an-s-corporation
[6] https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues
[7] https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations