What is an S corporation in the United States?

An S corporation (sometimes called an S Corp) is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once at the corporate level and again at the shareholder level) by electing to be treated as an S corporation.

An S corporation is a corporation with the IRS Subchapter S designation. To be treated as an S corporation, you must first register the business as a corporation in the state where it is based. According to the IRS, S corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits your financial liability as the owner, or “shareholder.” Still, the liability protection has limits: S corporations do not necessarily shield you from every lawsuit, such as an employee’s tort claim arising from a workplace incident. If you are about to invest in an existing corporation, you can confirm that the company is registered and active before you sign.

What sets an S corporation apart from a traditional corporation (C corporation) is that profits and losses can pass through to your personal tax return. As a result, the business itself is not taxed; only the shareholders are. There is one important caveat, though: any shareholder who works for the company must pay themselves “reasonable compensation.” Essentially, the shareholder must be paid fair market value, or the IRS may reclassify any additional corporate income as “wages.”

Everything in this post concerns US regulations, and every reference is grounded in business law principles.

Tax advantages of an S corporation

Tax savings. One of the best features of an S corporation is the tax savings for you and your business. While LLC members are subject to employment tax on all of the company’s net income, only the wages of an S corporation shareholder who is also an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which may be taxed at a lower rate. Deductions for business expenses. Some expenses incurred by shareholder-employees can be written off as business expenses. However, if an employee owns 2% or more of the shares, benefits such as health and life insurance count as taxable income. Independent existence. An S corporation designation also gives a business an existence of its own, separate from its shareholders. If a shareholder leaves the company or sells their shares, the S corporation can keep doing business with relatively little disruption. Keeping the business as a distinct corporate entity draws clear lines between the shareholder and the business, which strengthens the shareholders’ protection.

Disadvantages of an S corporation

Stricter operating processes.
As a separate structure, S corporations require scheduled director and shareholder meetings, minutes of those meetings, adopting and updating bylaws, stock transfers and recordkeeping.
Shareholder compensation requirements
A shareholder must receive reasonable compensation. The IRS watches for red flags, such as high distributions paired with low salaries, and may reclassify your distributions as wages. If an audit turns this up, you could end up owing more employment tax.

S corporation

Forming an S corporation

Before you form an S corporation, find out whether your business qualifies under the IRS rules.

To become an S corporation, you must first register as a corporation. Once you are treated as a corporation, all shareholders must sign and file Form 2553 to elect S corporation status for your corporation.

Once your company is registered, you must obtain your business licenses and permits. Regulations vary by industry, state and locality. Check with your city, county and state which permits and licenses apply to your business.

If you are hiring employees, read up on federal and state regulations for employers.

Combining the benefits of an LLC and an S corporation

You can always request S corporation status for your LLC. Your own legal or tax advisor can walk you through the pros and cons. You will need to make a special election with the IRS, using Form 2553, to have your LLC taxed as an S corporation. You must file it within two months and 15 days of the start of the tax year in which the election is to take effect.

The LLC remains a limited liability company from a legal standpoint, but for tax purposes it is treated as an S corporation. Be sure to check with the tax agency in the state where you will file the election form to learn its requirements.

Taxes

Most businesses need to register with the IRS, register with state and local revenue agencies, and obtain a tax permit or tax ID number.

Not all states tax S corporations the same way. Most recognize them as the federal government does and tax the shareholders accordingly. However, some states (such as Massachusetts) tax S corporations on profits above a specified limit. Other states do not recognize the S corporation election and treat the business as a C corporation, with all the tax consequences that entails. Some states (such as New York and New Jersey) tax S corporation profits as well as the shareholders’ proportionate shares of those profits.

Your corporation must file Form 2553 to elect “S” status within two months and 15 days after the start of the tax year, or at any time before the tax year, for the status to take effect.

Read more about IRS filing requirements for S corporations.

About the author

Zulma Eliana Bourelly

Zulma Eliana Bourelly is the founder of Riveros Corp (Riveros International Business Corp, Miami, Florida). Since 2009 she has helped entrepreneurs, companies, and religious and nonprofit organizations, both in the United States and from their home countries without traveling to the US, form and maintain their US companies and meet AML/KYC requirements. She has been a Florida Notary Public since 2010, with state registration as a Remote Online Notary (RON); a County Court Mediator certified by the Florida Supreme Court; a Certified Anti-Money Laundering Specialist (CAMS) by ACAMS; and a Certified Notary Signing Agent with the National Notary Association (NNA). She holds a law degree from the Universidad Nacional de Colombia and is not licensed to practice law in Florida or anywhere in the United States. She writes in Spanish and English about company formation, compliance and public records on US Jurisdiction, the group's blog. Service in Spanish, English and Italian. Legal notice: I AM NOT AN ATTORNEY LICENSED TO PRACTICE LAW IN THE STATE OF FLORIDA, AND I MAY NOT GIVE LEGAL ADVICE OR ACCEPT FEES FOR LEGAL ADVICE.