What Is an S Corporation (S Corp)? Main Pros & Cons

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If you have been operating your business as an unincorporated entity, such as a sole proprietorship or general partnership, you may have heard of S corporations and wondered what they are.

An S corporation, also known as an S corp, S subchapter, or a small business corporation, is a great way for small business owners to enjoy limited liability protection and pass-through taxation without the burdens of a C corporation. So let’s take a detailed look at what an S corp is and some of its pros & cons so you can see if an S corp is right for you.

What Is an S Corporation?

S corporations are a type of corporation that meet a set of requirements and make an election with the Internal Revenue Service (IRS) to be taxed under Subchapter S of the Internal Revenue Code (IRC). This is where they derive their name from, and it gives businesses numerous tax advantages.

S corporations may pass their income, deductions, credits, and losses onto their shareholders. This means that income is not taxed on the corporate level; instead, it is only taxed on the individual level, known as pass-through taxation.

S corporation status is designed for small businesses and is limited to a maximum of 100 shareholders. The S corp status gives small businesses the ability to receive the benefits of incorporation without the associated increase in taxes.

Important Details

  • An S corporation is a type of business corporation with numerous advantages for small businesses.
  • Corporations with 100 or fewer shareholders meeting the requirements for an S corp receive the benefits of incorporation while being taxed the same as a general partnership.
  • The shareholders receive the S corp’s income and report it on their own tax returns at ordinary tax rates.
  • Shareholders in an S corp are limited to individuals, specific types of tax-exempt entities, and certain trusts and estates.

S Corporations Explained

There are some requirements the IRS mandates a business must meet to qualify for becoming an S corporation. The standards include:

  • Domestic Incorporation: The business must have been incorporated within the U.S.
  • Stock Restriction: The business must only have one class of stock.
  • Limited Shareholders: The business must have a maximum of only 100 shareholders who meet standards of eligibility.

S corporation shareholders are restricted to individuals, certain 501 (c) (3) tax-exempt organizations, and certain trusts and estates. Groups ineligible to be shareholders include other corporations, partnerships, and nonresident aliens.

As we said, earlier S corporations receive their name from the tax election Subchapter S of the Internal Revenue Code. The important details you should know about being taxed as a corporation under Subchapter S include: S corporations may pass their income, losses, credits, and deductions onto their shareholders. This means the income does not face any federal corporate taxation, which is known as pass-through taxation. However, S corporations remain liable for corporate taxes on earnings from certain types of built-in gains and passive income.

Shareholders in an S corporation will simply report the earnings and losses the corporation receives on their own tax returns at the ordinary tax rates. This means the money passes through without paying corporate taxes and therefore does not face double taxation on any earnings.

But, outside of its advantageous tax status, an S corporation is very similar to the other type of corporation, the C corporation. An S corporation is run for profit and is regulated by the same state laws on corporations. They receive similar protection against personal liability and have the same advantages in ownership as C corporations. The S corporation also must abide by the same rules as a C corporation, such as having a board of directors, shareholder meetings, minutes of important mandatory meetings, and written corporate bylaws.


Filing as an S Corp

To become an S corporation, a business must first become incorporated. Then it must file Form 2553, “Election by a Small Business Corporation,” with the IRS. The IRS will review the form, and if it has been filled out properly, the business meets all requirements, the shareholders have signed the consent form, and an officer of the corporation signs it, they will accept it, granting you the advantageous status.

Now speaking of advantages, let’s take a look at the advantages and disadvantages of the S corporation.


S Corporation: Advantages and Disadvantages

There are many advantages to filing as an S corporation, and most businesses will benefit from it. But, there are some disadvantages, and these are important to consider, so let’s take a look at both before you decide if an S corporation is right for you.

Advantages of S Corporations

  • The biggest advantage most businesses receive from filing as an S corporation is the tax savings. These entities benefit from not having to pay federal corporate taxes on their earnings. This provides significant savings that most businesses will benefit from and especially from those that are just starting out.
  • Businesses claiming S corporation status can also benefit the business owners as well. The owners can credit the money they receive as salaries or dividends and thus avoid the greater liability they might receive from self-employment taxes. This status can also result in deductions from the wages paid to employees and from business expenses.
  • By acting as company employees, an S corporation’s shareholders can earn salaries and corporate dividends that will be tax-free up to the basis of their stock investment. Even if the dividends exceed the stock basis of a shareholder, the amount in excess will be taxed as capital gains, which are taxed at a lower rate than regular income tax.
  • Another advantage includes the ability to easily transfer ownership interests and adjust the basis of assets. Ordinarily, performing these tasks will result in negative consequences at tax time or simply involve navigating complex accounting rules.
  • Lastly, simply the status as an S corporation can help a small business establish greater credibility with investors, customers, vendors, and even its own employees. This is due to showing a significant legal commitment to the company itself and its shareholders.

Disadvantages of S Corporations

  • A disadvantage of S corporations is related to one of its biggest advantages. Due to the ability to assign salaries, this could encourage fraudulently assigning corporate distributions as salaries to reduce taxation.
  • This results in a great deal of IRS scrutiny on S corporation payrolls. This makes it crucial for S corporations to pay attention to how they pay shareholders who are also employees to ensure it appears reasonable for the position before any corporate distributions.
  • S corporations face the restriction on corporate distribution that they may only allocate profit and loss based on the percentages of ownership any shareholder possesses. Shareholders must also receive distributions, regardless of their individual voting rights.
  • If an S corporation violates these or any other regulations such as in elections, filing rules, notifications, or consent, then the IRS can terminate their status in Subchapter S. Luckily, this is rare as well as other adverse treatment, as long as the business takes effort to return to compliance with regulations.
  • Unfortunately, attempting to incorporate as an S corporation or any corporation can be a costly and time-intensive process. The owner must file an Article of Incorporation with their states’ Secretary of State, select a registered agent, and pay numerous fees along the way.
  • Depending on the state of incorporation, there may be fees associated with submitting the company’s annual report, as well as franchise taxes and other fees. Most of these fees are not very large and can still be filed as a business cost for the deduction.
  • Lastly, the requirements on shareholders can be burdensome, especially for growing businesses. It can dissuade and outright bar many investors, including venture capitalists and other businesses who may have been interested had the business been a C corporation.

In Short: Main S Corporation Pros & Cons

Pros

  • Lower Taxes: S Corporations do not pay corporate taxes, meaning their owners do not pay self-employment taxes and avoid double taxation.
  • Incorporation: Being incorporated provides owners numerous advantages, including limited liability and easy transfer of ownership interests.
  • Appearance: Being formally recognized as an S corporation can add significant credibility to a small business.

Cons

  • Costly: There are numerous fees to pay to incorporate.
  • Complexity: There are numerous rules and responsibilities related to being an S corporation that must be adhered to.
  • Growth Limitations: To maintain its status, an S corporation must adhere to standards on the number and type of shareholders it can have, which can limit its growth.

S Corporations and LLCs

Another common business structure small businesses choose is limited liability companies (LLC). This form of legal business structure is similar in many respects to an S corporation, so let’s take a look at and compare the two.

Both LLCs and S corporations benefit from pass-through taxation, which means neither are required to pay corporate taxes. Also, both provide their owners with limited liability, which protects the owners’ assets from the business’s losses. This means that the owners’ personal assets are unaffected by the business’s debts and are not held responsible if the business is sued.

But, there are differences; firstly, an LLC has fewer restrictions. LLC’s do not face regulations on either the number or type of people eligible to invest and become owners or, as they are often referred to with LLCs, “members.” They also do not face federal and state rules on how they distribute funds or structure their management. The owners of an LLC have the freedom to distribute the company’s earnings between its owners in whatever proportions they choose.

Finally, an LLC is easier to form than an S corporation. But, they have more limited options for receiving financing than an S corporation, often leaving them to bank loans rather than equity investment. Due to the more limited growth potential, they are often chosen by sole proprietors and small professional groups, such as attorneys, dentists, or accountants.


S Corporations and Federal Income Tax Returns

S corporations generally do not owe federal corporate taxes. However, they are still required to file a tax return with the IRS reporting their income.

This is reported on Form 1120-S, “U.S. Income Tax Return for an S Corporation.” Form 1120-S reports how much income, loss, and corporate distributions the S corporation has passed to its shareholders. This form will often be filed alongside Schedule K-1, which will report the percentage of shares belonging to each shareholder.

C corporations are required to file taxes quarterly. But, S corporations like individual taxpayers must only file their taxes annually. An S corporation’s tax filing on Form 1120-S is also much easier than filing the C corporation equivalent.

If a company chooses to file for S corporation status and succeeds, then it is required to file its taxes with Form 1120-S. An S corporation’s filing deadline for taxes is on the third month and 15th day after its fiscal year ends, which, if it chooses to follow the fiscal year, will be March 15th.

Just like individual taxpayers, an S corporation may request a six-month filing extension from the IRS through filing Form 7004, “Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns.”


Why Should You Choose to Form an S Corporation?

S corporations can combine the best benefits of both a C corporation and a sole proprietorship is one package for small business owners.

More specifically, an S corporation gives its owners the same limited liability protection that C corporations do. Meaning an S corporation’s owners’ personal assets are protected in case of debts or lawsuits arising against the company.

Yet, they still retain the pass-through taxation of sole proprietorships or general partnerships. Additionally, by classifying its owners’ earnings from the company as a dividend or salary, they can avoid paying self-employment tax on their income.


What Does S Corporation Mean?

S corporations are named for the part of the Internal Revenue Code that they request to be taxed under. This is Subchapter S of Chapter 1 of the Internal Revenue Code, and after requesting if it is approved, they must be taxed under these provisions. This is also why they are sometimes referred to as S subchapters.


How Does an S Corp Work?

In general, S corporations work in much the same way as any corporation does in the state it’s incorporated in. S corporations have a board of directors, corporate bylaws, management structure, and corporate officers. The owners of both are protected from financial liability for claims against the business. Finally, like other corporations, it will issue shares of stock.

What distinguishes an S corporation is the lack of federal taxation on most types of earnings it creates and distributes to its owners. This results in greater earnings passed to its owners, who must pay income taxes on it at normal rates. These distributions to shareholders must be performed based on the percentage of ownership belonging to each of its shareholders.

An S corporation is further distinguished by who can invest in it. S corporations must allow a maximum of 100 members, who must be from qualifying categories. This includes individuals, certain trusts, and certain non-profit organizations. In addition, both the company and its owners must be based in the U.S.

Finally, an S corporation must issue a Schedule K-1 to its shareholders that show their annual profit or loss from the business, and they will file Form 1120-S to report their earnings or loss to the IRS.


Is an LLC or an S Corp Better?

To decide between an LLC and an S corporation, the type, current size, and potential for growth should all be considered.

In general, for small businesses such as sole proprietorships or those with only a few partners, LLCs are generally a good choice. But for larger businesses or ones with high growth potential, an S corporation is generally a better choice.

An S corporation has greater options to acquire financing, and unlike an LLC, they offer investors shares of ownership in the company. Also, larger businesses can benefit from the otherwise cumbersome structures and regulations that govern corporations.


How are S Corporations and C Corporations Different?

The biggest difference between S corporations and C corporations is the taxes they pay. Specifically, the ones C corporations pay and S Corporations generally do not.

C corporations are required to pay a 21% flat corporate tax rate on everything they earn. After this, when they distribute earnings to their shareholders, the shareholders must pay taxes on the earnings. But, with an S corporation’s earnings, they are exempt from most federal taxation outside of passive income and specific types of capital gains. This means they have much more left to distribute to their shareholders.

However, this benefit does come to S corporations at the cost of significant restrictions placed by the IRS. Both the S corporation itself and all of its shareholders are required to be based in the U.S. An S corporation is limited to only one class of stock and a maximum of 100 shareholders, who must be individuals, certain non-profits, and certain trusts and estates.

In contrast, a C corporation is free from all of the restrictions, and generally, this type of corporation is chosen by businesses larger than S corporations.


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Final Thoughts

An S corporation is one of the best and most common choices of business structure for small businesses. They have all the tax advantages of a sole proprietorship or partnership and the limited liability protection offered by corporations while being easier to form and run than a C corporation.

An S corporation faces many of the same rules and expenses that other corporations face, including the original cost of incorporating. Plus, they are costlier and harder to make and run than an LLC, which is a popular alternative to S corporations.

An S corporation is a great choice for many small businesses, and though the restrictions on size and type of shareholder can be cumbersome, if you choose to switch to a C corporation, it isn’t difficult to do.

So, if you are looking to start a small business or potentially grow your current one, don’t hesitate to file as an S corporation. This structure has many advantages and few disadvantages for small businesses.

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Ian Broderick is an avid author and owner of LLCGuys.com. He's been involved with the LLC formation field for over 4 years. On top of that, he has worked in several well-known LLC formation service providers. Now he decided to share his knowledge and advice with everybody. Since there are a lot of questions and concerns surrounding this field - his aim is to make LLCGuys a top-notch information provider in regards to LLC creation, service reviews and etc..

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