S Corp Definition
An S corporation (S corp) is an IRS tax designation available to corporations and LLCs. Depending on your company’s specific characteristics and needs, you may find it advantageous to elect S corp status.
Forming an S corp is a popular option for owners of both LLCs and corporations, providing each of those business structures with distinct advantages.
When a company elects S corp status, it’s taxed as a pass-through entity. This means the company doesn’t pay any tax on earnings at the corporate level. Instead, the company’s profits or losses pass through directly to the owners’ personal tax returns.
Owners of S corps who play an active role in the company also are considered employees, which means they receive a salary. This differs from the owners of LLCs, who instead take owner’s draws to pay themselves.
S Corp Taxes
Like LLCs and partnerships, S corps are taxed as pass-through entities. This means S corps don’t pay a federal corporate income tax on their business earnings. Instead, the company’s profits or losses pass through to the owners — also known as shareholders. The shareholders then report their share of the profits in the form of salaries on their individual tax returns and pay personal income tax on that amount.
Owners of an S corp that play an active role in the company are considered employees and must receive a “reasonable” salary (earned income) based on their specific position and the company’s industry. This salary is subject to both personal income tax and employment tax. In addition to this salary, owners may take draws from the company’s remaining profits. Those draws are only subject to personal income tax. After all distributions are allocated and properly taxed, the remaining business profits are considered “retained earnings.”
This differs from the default tax structure of LLCs. While the IRS also considers LLCs as pass-through entities, all of an LLC owner’s income is subject to both personal income tax and employment tax. An S corp’s tax structure also differs from the tax structure of standard C corporations (C corps), which face “double-taxation.” A C corp must pay a federal corporate income tax and then its shareholders must pay a tax on their dividends.
Should I Form an S Corp?
The decision to form an S corp will depend on your company’s unique needs and circumstances. Understanding the key advantages and disadvantages of S corp status will help you make that decision.
S Corp Advantages
For LLC owners, one of the biggest advantages of electing S corp status is potentially paying less self-employment tax. With the default LLC tax structure, all of the income an owner makes from the company is subject to self-employment tax. But, with an S corp, the owner must only pay self-employment tax on the amount they earn as salary. Any additional draws (distributions) they take from the company’s profits aren’t subject to self-employment tax.
For C corp owners, the main advantage of the S corp tax structure is that their company’s profits avoid “double-taxation.” C corps must pay a federal corporate income tax on their profits and then the dividends shareholders receive are taxed on their individual tax returns. Businesses that elect to be taxed as an S corp are considered pass-through entities, which aren’t subject to federal corporate income tax.
S Corp Disadvantages
Compared to LLCs, S corps require more paperwork and must follow more regulations. Because S corps aren’t considered disregarded entities for tax purposes (like single-member LLCs are by default), the IRS scrutinizes them more closely. That means you must be extra diligent with financial record keeping and tax filing.
There’s also a limit on the number of owners (called shareholders) that an S Corp may have — usually 100. This differs from both LLCs and C corps, which have no limitation on the number of owners.
One other potential disadvantage of S corps compared to C corps is that passive income distributed to shareholders is taxed at the same rate as ordinary income tax. In contrast, C corp shareholders may be eligible to pay a lower tax rate on their dividends.
How to Form an S Corp
Use How to Start an S Corp guide to start an S corp yourself.
To be eligible to be an S corp, a business must meet the following criteria:
- Its shareholders can’t be corporations or partnerships
- It can’t have more than 100 owners
- All owners must be U.S. citizens or permanent residents
- Owners’ profits and losses must be allocated proportionally by ownership stake
- If the company is a C corp, it must only have one class of stock
How to Start a Business
After you familiarize yourself with the advantages and disadvantages of an S corp and decide if it’s the right business structure for you, you will then need to actually form the business. Whether you choose to be taxed as an S corp or not, you must complete several other tasks before you can start selling your products or services.
For more details on those other tasks, check out our state-by-state How to Start a Business guides. In the meantime, here’s a quick overview of some basic steps you must take after forming your business:
- Register for taxes
- Create business banking and credit accounts
- Set up accounting
- Obtain required licenses and permits
- Get appropriate insurance
- Establish a web presence
S Corp FAQs
What is an S corp?
An S corporation (S corp) is a tax designation for which an LLC or a corporation may apply. An S corp is owned by shareholders, but there’s a limit to the total number of shareholders (usually 100) and profits aren’t taxed at the corporate level. Instead, profits or losses pass through to the shareholders’ individual tax returns.
Is an S corp an LLC?
No. An S corp is a tax designation for which an LLC or a corporation may apply.
How do you form an S corp?
You can form an S corp by filing Form 2553 with the IRS.
What are the requirements for an S corp?
S corps must meet four requirements:
- They can have no more than 100 shareholders.
- All shareholders must be private individuals — not other business entities.
- Shareholders can’t be nonresident aliens.
- The business may only issue one class of stock.
What are the benefits of an S corp?
S corps don’t face double taxation like C corporations (C corps). Additionally, owners of S corps are considered employees of their company so they can save thousands of dollars on self-employment taxes.
What is the S corp tax rate?
There’s no corporate tax rate for S corps. Instead, owners of S corps pay personal income tax on the company’s profits. This rate depends on each owner’s personal income tax bracket.
What is pass-through taxation?
Pass-through taxation is a system of taxation that generally applies to sole proprietorships, partnerships, LLCs, and S corps. In this system, the profits or losses of the business aren’t taxed at the company level. Instead, they pass through to the owners’ personal tax returns and are taxed at each owners’ personal income tax rate.