Why Would You Choose an S Corporation?
Choosing to classify your limited liability company (LLC) as an S corporation (S corp) with the Internal Revenue Service (IRS) can have tax advantages.
For example, S corp owners are taxed as employees of the company and don’t have to pay self-employment tax on dividends and distributions. S corps enjoy other benefits as well.
Read on for more details about why you might want to elect S corp status for your business.
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What Is an S Corporation?
The IRS taxes S corps under Subchapter S of the Internal Revenue Code. The IRS defines an S corp as follows:
S corporations are corporations or other entities eligible to be treated as a corporation that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
Like a C corporation (C corp), an S corp issues stock and has directors, officers, and shareholders.
In addition, owners of S corps have limited liability protection like the owners of LLCs and C corps. This protects the owners’ personal assets from exposure if the company faces lawsuits or debt repayments.
An LLC or a corporation can choose — or “elect” — S corp status. If a company makes this election, the IRS will tax it as an S corp rather than in the default manner of taxation for an LLC or corporation.
If the owner of an LLC elects S corp status, the IRS will tax that owner as an employee of the LLC. This can result in significantly reduced self-employment taxes in some cases.
If the owner of a corporation elects S corp status, the IRS will tax the company as a pass-through entity. This will prevent the business from paying double corporate taxes.
For more information, see our What Is an S Corporation? article. In addition, visit our LLC vs. S Corp guide to learn more about when to use the S corp election.
For more information about S corps and C corps, check out our guide on S Corp vs. C Corp: What’s the Difference?
If you’re trying to decide how to structure your business, read our guide on How to Choose a Business Structure.
Recommended: Collective can start your S corp, manage your monthly accounting (bookkeeping, payroll), identify potential tax savings, and more. You'll have a personalized advisor and an additional team in your corner, so you can focus more on your business needs.
Advantages and Disadvantages of an S Corporation
Electing to classify your business as an S corp can provide several advantages. These include several tax advantages as well as a few other types of benefits.
But, not every business should elect S corp status. You also must consider the disadvantages that come with this election before doing so.
Read on for an in-depth explanation of the advantages and disadvantages of S corps.
Advantages of an S Corp
The main advantages of S corp status include:
- Pass-through taxation
- Asset protection
- Reduced self-employment taxes
- The ability to easily transfer ownership
Unlike a C corp, an S corp doesn’t pay corporate federal taxes. Instead, the business’s income passes through to its owners.
The owners must then pay tax on their portion of the income, which they report on their personal federal income tax returns. S corp owners also can take business losses on their personal tax returns, which can offset income they may earn from other sources.
The owner of a sole proprietorship can face personal liability if someone sues their company or a debt collector demands payment. That’s because a sole proprietorship isn’t legally separate from its owner.
In contrast, an S corp is legally separate from its owner. This means only the corporate assets — not the owner’s personal assets — face exposure in the event of a lawsuit or some other liability.
For more information, see our Sole Proprietorship vs. S Corp article.
Reduced Self-Employment Taxes
Because the IRS views S corp owners as employees, they pay self-employment and income taxes on the salary they draw from the company. But, owners don’t pay self-employment tax on dividends and distributions. This can potentially reduce an owner’s overall tax bill.
Simplified Transfer of Ownership
The owner of an S corp can transfer their interest without the tax consequences that can result from transferring an interest in an LLC or partnership. Moreover, the tax and accounting rules for transferring interest in an S corp are less complicated.
Disadvantages of an S Corp
Although S corps enjoy many advantages, they also have several disadvantages. These include:
- Ongoing fees
- More IRS scrutiny
- More rules to follow
- Taxation on fringe benefits
- Stock limitations
Many states require S corps to pay fees on annual reports, franchises, or other items. While these fees aren’t particularly high and S corps can write them off as business expenses, other types of business (e.g., sole proprietorships) don’t have to pay them.
More IRS Scrutiny
The IRS knows businesses elect S corp status to reduce their tax burden. As a result, it tends to look at S corps more closely than some other businesses to ensure they follow the rules. In particular, the IRS will look to see that an S corp realistically characterizes its wages and dividends.
More Rules to Follow
An S corp must follow rules that don’t apply to regular LLCs and sole proprietorships. These include rules surrounding dividends, stock ownership, filing requirements, corporate formalities, and more. If a company fails to follow these rules, it can lose its S corp status.
Taxation on Fringe Benefits
Employees of corporations, including S corps, must pay taxes on most fringe benefits they receive if they own more than 2% of the company.
Unlike C corps, S corps may only issue one class of stock. While S corps can choose to issue either voting or non-voting stock, they can have just one class of investor.
In addition, S corps may have no more than 100 shareholders. They also can’t be owned by a foreign person or entity or by some domestic entities.
When to Choose an S Corporation
Before choosing S corp status, talk to your accountant to see if it would save you money on your business taxes. Becoming an S corp could reduce taxes if the business:
- Meets S corp restrictions;
- Earns enough in net profit to pay its owner(s) a "reasonable salary" and at least $10,000 in distributions annually; and/or
- Will realize enough tax savings to more than make up for the payroll and accounting costs that come with an S corp election.
S Corp Restrictions
Under IRS rules, a business must meet these requirements in order to elect S corp status:
- Have no more than 100 shareholders
- Issue only one class of stock
- Be owned by US citizens or permanent residents
- Be owned by private individuals and not business entities, such as LLCs, corporations, or trusts
Net Profit, ‘Reasonable Salary,’ and Distributions
Electing S corp status will only potentially reduce a business’s tax burden if it has sufficient net profits to pay the owners a “reasonable salary” as well as at least $10,000 in distributions every year. A “reasonable salary” represents the amount a person would normally earn to do the same job.
To see what people typically earn in a given job, visit websites like Glassdoor and the US Bureau of Labor Statistics.
Payroll and Accounting Costs
S corps must maintain payroll and accounting — tasks usually performed by trained professionals. Make sure any tax savings from electing S corp status will more than compensate for their salaries and benefits.
Check out our S corp tax calculator to find out more about you business's potential tax savings.
Recommended: Let Collective manage your monthly accounting (bookkeeping, payroll) and find your potential tax savings with a personal advisor and team!
How to Start an S Corporation
If you want to start an S corp, you have two ways to do so.
The first option involves forming an LLC and then electing S corp status from the IRS when you request your Employer Identification Number (EIN). The second option involves forming a corporation and then electing S corp status.
We recommend forming an LLC and electing S corp status. Our guides can help you start an LLC, or you can use a company like ZenBusiness to do it for you.
To elect S Corp status, you must take the following steps:
- Name your LLC.
- Choose a registered agent.
- File your LLC’s Articles of Organization.
- Create an LLC operating agreement.
- Obtain an EIN and file Form 2553 to elect S corp status.
Step 1: Name Your LLC
Your LLC needs a unique name that no one else already registered. Designate the name in your LLC’s formation documents.
Need help naming your LLC? Check out our Business Name Generator and How to Name a Business guide.
Step 2: Choose a Registered Agent
A registered agent is a person or entity you designate to accept service of process and other legal and tax documents on your LLC’s behalf. You’ll need to list a registered agent as part of your LLC’s Articles of Organization.
Step 3: File Your LLC’s Articles of Organization
The Articles of Organization is the document you must file to officially register your LLC with the appropriate state agency. Some states call this document a Certificate of Formation or Certificate of Organization.
Step 4: Create an LLC Operating Agreement
An operating agreement designates how your LLC will function. Among other things, it lists the members and their responsibilities.
Step 5: Obtain an EIN and File Form 2553
The IRS uses EINs to identify businesses for tax purposes. There’s no charge to apply for an EIN directly with the IRS.
What is an S corp?
An S corp isn’t a type of business entity. Rather, it’s a tax status that the owner of an LLC or corporation can elect. This tax status can save the owner money in some situations.
What are the benefits of an S corp vs. an LLC?
The owner(s) of an LLC classified as an S corp won’t pay self-employment tax on all distributions from the business. Instead, the owner(s) will pay income tax on distributions plus both self-employment and income taxes on the salary they draw from the company.
Under the right conditions, this can result in about a 17% tax savings on distributions. For the owner(s) of a corporation, S corp status means the company can avoid double taxation because the IRS will then tax the corporation as a pass-through entity.
Should I file as an S corp?
If you haven’t yet formed an LLC, you may do so with S corp status. Alternatively, you may choose S corp status for your existing LLC.
In either case, seek the advice of an accountant to ensure S corp status will result in tax savings for your specific business.
What are the benefits of an S corp vs. a C corp?
Choosing S corp tax status enables business owners to elect to have the IRS tax them as employees of the company. In some situations, this can result in tax savings.
C corps can attract investors because shareholders only pay taxes on their dividends from the company.
C corps also can enjoy certain tax advantages. For example, the IRS taxes them just 15% on profits they carry over from year to year.
How do I fill out Form 2553?
LLCs and corporations use Form 2553 to elect S corp classification from the IRS. To file Form 2553, follow these steps:
- Confirm your business’s eligibility to elect the S corp classification.
- Check the due dates for filing Form 2553.
- Complete and file Form 2553.
For more information, see these detailed Instructions for IRS Form 2553.