An S corp, or S corporation, is a business structure that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes. This classification, falling under the broader category of business structures and taxation, allows the entity to avoid the "double taxation" typically associated with traditional corporations, where profits are taxed at both the corporate level and again at the individual shareholder level when distributed as dividends. Instead, an S corp's income and losses are reported on the shareholders' personal tax returns, with taxes assessed at their individual income tax rates.41
History and Origin
The concept of the S corp originated from a desire to mitigate the heavy tax burden on small businesses in the mid-20th century. Before the creation of Subchapter S, entrepreneurs typically faced a dilemma: form a traditional corporation (C corp) to enjoy limited liability but endure double taxation, or operate as a sole proprietorship or partnership to avoid entity-level taxes but forgo liability protection.40
In 1946, the U.S. Department of the Treasury proposed a new option that would merge single-layer taxation with comprehensive liability protection.39 This recommendation gained traction, leading to the enactment of Subchapter S of the Internal Revenue Code in 1958, during the Eisenhower administration.,38 This legislative change was a significant step forward, reducing an oppressive level of tax and encouraging the creation and growth of small and family businesses across the United States.37 The Tax Reform Act of 1986 further influenced the popularity of the S corp, as certain C corporations converted to S status to take advantage of lower individual tax rates.36
Key Takeaways
- An S corp is a special tax election available to eligible corporations and LLCs, allowing them to avoid corporate-level income tax.35,34
- Income, losses, deductions, and credits "pass through" directly to the shareholders, who report them on their personal tax returns.33
- S corps offer limited liability protection to owners, shielding personal assets from business debts and lawsuits, similar to a traditional corporation.32
- To qualify, an S corp must meet specific IRS criteria, including being a domestic corporation, having no more than 100 shareholders (who must be individuals, certain trusts, or estates), and having only one class of stock.31
- Shareholder-employees of an S corp must pay themselves a "reasonable salary" subject to payroll taxes before taking distributions, to prevent mischaracterizing wages as tax-free distributions.30
Interpreting the S corp
An S corp is primarily a tax designation rather than a distinct legal entity type. A business first forms as a corporation or a Limited Liability Company (LLC) under state law, and then elects S corp status with the IRS.29 The core interpretation hinges on its pass-through nature, meaning the business itself typically does not pay federal income tax. Instead, the profits and losses are allocated to the owners based on their proportional ownership of shares and are reported on their individual tax returns.28
This structure can simplify the tax obligations for small business owners and can lead to potential tax savings, particularly by allowing them to separate their compensation into a reasonable salary (subject to payroll taxes) and distributions (which are generally not subject to self-employment taxes).27 Understanding an S corp involves recognizing that while it provides the corporate veil protection of a traditional corporation, its tax treatment mirrors that of a partnership or sole proprietorship.
Hypothetical Example
Consider "GreenThumb Landscaping Inc.," a small business incorporated in Delaware by its two founders, Alex and Ben. They each own 50% of the company's stock. After filing their Articles of Incorporation with the state, they decide to elect S corp status by filing Form 2553 with the IRS, aiming to avoid double taxation.
In its first year, GreenThumb Landscaping Inc. generates $200,000 in business income before salaries. Alex and Ben, both actively working in the business, pay themselves a "reasonable salary" of $60,000 each. This $120,000 in salaries is deducted from the company's income, leaving $80,000 in net profit.
This $80,000 is the S corp's pass-through income. Instead of the corporation paying tax on this amount, it is divided equally between Alex and Ben, who each receive a Schedule K-1 reflecting $40,000 of their share of the company's income. They then report this $40,000 on their personal tax returns. The $60,000 salaries they paid themselves are also reported on their personal returns as wages. The $40,000 distribution each receives, representing their share of the profit after salaries, is generally not subject to self-employment taxes, offering a potential tax advantage.
Practical Applications
The S corp structure is widely used by small to medium-sized businesses across various industries, from professional services and retail to technology startups. Its primary appeal lies in tax efficiency and liability protection.
- Tax Savings for Owners: By electing S corp status, owners can often reduce their overall tax burden. They can draw a reasonable salary subject to Social Security and Medicare taxes, while additional profits distributed to them as distributions are generally not subject to these self-employment taxes.26 This strategy can be particularly advantageous for highly profitable small businesses.
- Asset Protection: Like a C corp, an S corp provides limited liability for its shareholders. This means the personal assets of the owners are typically protected from business debts and lawsuits, providing a crucial layer of security.
- Fringe Benefits and Expense Deductions: S corps can offer certain fringe benefits to employee-shareholders, though the tax treatment of these benefits can differ from C corps, especially for shareholders owning more than 2% of the company. The entity can also deduct legitimate business expenses, further reducing taxable income.
- Estate Planning: The ability to transfer ownership shares, combined with the pass-through taxation, can make an S corp a useful tool in estate planning, allowing for smoother transitions of business ownership.
The IRS provides guidance on the requirements and implications of S corporation status, detailing how businesses can make and maintain this election.25
Limitations and Criticisms
Despite its advantages, the S corp structure has several limitations and faces certain criticisms:
- Eligibility Restrictions: S corps are subject to strict IRS requirements. They cannot have more than 100 shareholders, all of whom must generally be U.S. citizens or residents (certain trusts and estates are permitted, but partnerships, corporations, and non-resident alien shareholders are excluded).24 Additionally, an S corp can only have one class of stock, though differences in voting rights are allowed.23 These restrictions can limit growth and fundraising options compared to C corps.
- "Reasonable Salary" Scrutiny: The IRS closely scrutinizes the salaries paid to shareholder-employees of an S corp. If the salary is deemed unreasonably low, the IRS can reclassify distributions as wages, subjecting them to payroll taxes and potentially penalties. This requires careful planning and often professional guidance to ensure compliance.22
- Tax Complexity: While aiming for simplicity by avoiding double taxation, S corp tax compliance can still be complex. Owners must understand how to properly track their basis in the company, as distributions beyond this basis can be taxed as capital gains.21
- Limited Capital Raising: The single class of stock rule and shareholder limits can hinder an S corp's ability to raise capital from diverse investors or through complex equity financing rounds, which are common for rapidly growing companies.
- State-Level Differences: Not all states treat S corps identically to the federal government. Some states may impose entity-level taxes or have different filing requirements for S corps.20 The IRS provides further information on frequently asked questions and common considerations for S corporations.
S corp vs. C corp
The fundamental distinction between an S corp and a C corp lies in their taxation structure. Both are legal corporate entities that offer limited liability protection to their owners. However, a C corp is taxed as a separate entity: its profits are taxed at the corporate level, and then again when profits are distributed to shareholders as dividends (known as double taxation).19 In contrast, an S corp is a pass-through entity, meaning corporate income and losses are "passed through" directly to the owners' personal income tax returns, thereby avoiding the corporate level of taxation.18
| Feature | S corp | C corp |
|---|---|---|
| Taxation | Pass-through taxation; income/losses reported on owners' personal tax returns. Avoids double taxation. | Entity-level taxation; profits taxed at corporate level, then again when distributed as dividends (double taxation).17 |
| Shareholders | Limited to 100 shareholders; must be U.S. citizens/residents or certain trusts/estates.16 | Unlimited number of shareholders; no residency restrictions.15 |
| Stock Classes | Only one class of stock permitted (differences in voting rights allowed).14 | Multiple classes of stock possible (e.g., common and preferred).13 |
| Ownership | Cannot be owned by corporations, partnerships, or non-resident aliens.12 | Can be owned by other corporations, partnerships, or international investors.11 |
| Profit Handling | Profits can be distributed as a combination of reasonable salary (subject to payroll tax) and distributions (not subject to self-employment tax).10 | Profits primarily distributed as dividends (subject to double taxation) or can be retained as retained earnings.9 |
Choosing between an S corp and a C corp depends on factors such as the business's anticipated growth, desired number and type of investors, and strategic tax planning. The IRS offers a direct comparison of these two corporate structures.8
FAQs
What are the main requirements to qualify as an S corp?
To qualify as an S corp, a business must be a domestic corporation, have no more than 100 shareholders, and have only one class of stock. Shareholders must typically be individuals, certain trusts, or estates, excluding partnerships, corporations, and non-resident aliens.7, The election is made by filing Form 2553 with the IRS.6
How does an S corp avoid double taxation?
An S corp avoids double taxation by electing to be a pass-through entity. This means that the corporation itself does not pay federal income tax. Instead, its income and losses are "passed through" directly to the shareholders, who report these amounts on their personal tax returns.5
Do S corp owners have to pay themselves a salary?
Yes, if an S corp owner performs services for the company, the IRS requires them to pay themselves a "reasonable salary" that is subject to payroll taxes. This prevents owners from reclassifying all their income as tax-free distributions to avoid self-employment taxes.4
Can an LLC be taxed as an S corp?
Yes, a Limited Liability Company (LLC) can elect to be taxed as an S corp. While an LLC is typically taxed as a sole proprietorship or a partnership by default, it can choose to be taxed as a corporation and then further elect S corp status by filing Form 2553 with the IRS.3
What are the compliance requirements for an S corp?
S corps must adhere to corporate formalities similar to C corps, such as adopting by-laws, appointing directors and officers, and maintaining corporate records. They also have specific tax filing requirements, including filing Form 1120-S annually with the IRS and providing Schedule K-1 to each shareholder.2,1