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S corporation

What Is S Corporation?

An S corporation, often referred to as an S corp, is a type of business entity that has elected a special tax status with the U.S. Internal Revenue Service (IRS). Within the realm of business structures and taxation, S corporations offer a unique hybrid that combines the advantages of a corporation's limited liability with the tax efficiencies of a partnership or sole proprietorship. This means that, for federal tax purposes, the S corporation itself generally does not pay corporate income tax directly. Instead, the company's income, losses, deductions, and credits are "passed through" to its shareholders to be reported on their individual income tax returns.,46 This mechanism is known as pass-through taxation.

History and Origin

The concept of the S corporation was introduced in the United States to address the challenges faced by small businesses. Before its inception, businesses typically had to choose between operating as a standard corporation, which incurred "double taxation" on profits (first at the corporate level, then again when distributed to owners as dividends), or as unincorporated entities like partnerships, which offered no limited liability protection for their owners' personal assets.45

To bridge this gap, Congress enacted the Technical Amendments Act of 1958, adding Subchapter S to the Internal Revenue Code.44,43 This legislation created the S corporation status, allowing small businesses to enjoy the corporate form's liability protection while avoiding the burden of corporate-level income tax.42 Initially, there were strict limitations, such as a maximum of 10 shareholders. Over the years, the provisions governing S corporations have been revised multiple times, including an increase in the maximum number of shareholders to 100 in 2004, and the inclusion of a deduction for pass-through business owners in the Tax Cuts and Jobs Act of 2017.41,40,39

Key Takeaways

  • An S corporation is a business entity that elects a special tax status, allowing income and losses to pass directly to shareholders' personal tax returns, thereby avoiding federal corporate income tax.,38
  • Shareholders of an S corporation benefit from limited liability, protecting their personal assets from business debts and lawsuits.37,36
  • To qualify for S corporation status, businesses must meet specific IRS requirements, including being a domestic corporation, having no more than 100 shareholders, and having only one class of stock.35
  • A key advantage of the S corporation is the potential for self-employment tax savings, as owners can often split their income into a "reasonable salary" (subject to payroll taxes) and distributions (not subject to self-employment tax).34,
  • The election to become an S corporation is made by filing Form 2553 with the IRS.

Formula and Calculation

While there isn't a direct "formula" for an S corporation's overall taxation like a simple profit calculation, the core principle revolves around the allocation of income and losses to shareholders.

The S corporation computes its taxable income similar to a C corporation, but then this income (or loss) is passed through to the shareholders. Each shareholder receives a Schedule K-1 from the S corporation, detailing their share of the company's income, deductions, credits, and other items. The amount reported on a shareholder's Schedule K-1 is generally proportional to their ownership percentage.

For example, if an S corporation has net income (profit) of $100,000 for a tax year and a shareholder owns 25% of the company, that shareholder will report $25,000 of income on their personal tax return (Form 1040), regardless of whether they received a cash distribution.

A critical aspect for shareholder-employees of an S corporation is the division of their compensation into salary and distributions. The reasonable salary portion is subject to payroll taxes (Social Security and Medicare), while distributions are not.

The total amount of income reported by a shareholder is then subject to their individual income tax rates.

Shareholder’s Taxable Income Portion=S Corp Net Income×Shareholder’s Ownership Percentage\text{Shareholder's Taxable Income Portion} = \text{S Corp Net Income} \times \text{Shareholder's Ownership Percentage}

Interpreting the S Corporation

Understanding the S corporation structure is vital for small business owners and investors alike. Its primary interpretation centers on its tax-advantaged status as a pass-through taxation entity. Unlike traditional C corporations, which are subject to corporate income tax at the entity level before any remaining profits are distributed to shareholders (who then pay taxes on those distributions, leading to "double taxation"), an S corporation generally avoids this dual layer of taxation.33

For entrepreneurs, this means that business profits are taxed only once, at the individual shareholder's level. This can lead to a lower overall tax burden, particularly for profitable small businesses. The structure also provides the advantage of limited liability, protecting the personal assets of the owners from the business's debts and obligations, a benefit typically associated with corporations.32 Furthermore, the S corporation can enhance credibility with clients and suppliers, similar to a traditional corporate structure.

Hypothetical Example

Consider "Green Thumb Landscaping LLC," owned equally by two individuals, Alice and Bob. Initially, it's taxed as a multi-member limited liability company (LLC), where all profits are subject to self-employment tax.

In their third year, Green Thumb Landscaping earns a net profit of $120,000. Alice and Bob decide to elect S corporation status to potentially reduce their self-employment tax burden. They file Form 2553 with the IRS. As co-owners, they also serve as employees. After consulting with a tax professional, they determine a "reasonable salary" for their services is $40,000 each.

  • Total S Corp Net Profit: $120,000
  • Alice's Salary: $40,000 (subject to payroll taxes, including self-employment tax)
  • Bob's Salary: $40,000 (subject to payroll taxes, including self-employment tax)
  • Remaining Profit: $120,000 - ($40,000 + $40,000) = $40,000

This remaining $40,000 is distributed to Alice and Bob as distributions, based on their 50/50 ownership. So, Alice receives a $20,000 distribution, and Bob receives a $20,000 distribution. These distributions are generally not subject to self-employment tax. Both Alice and Bob will report their $40,000 salary and $20,000 distribution (totaling $60,000 each) on their individual income tax returns, leveraging the pass-through taxation benefits of the S corporation.

Practical Applications

S corporations are widely used by small to medium-sized businesses across various industries due to their favorable tax treatment and liability protection. One common application is for professional service firms, such as consulting agencies, accounting practices, or law firms, where owners want to protect personal assets while managing tax liabilities effectively. The ability for owner-employees to receive both a salary and distributions offers strategic tax planning opportunities, particularly regarding self-employment tax contributions.31

In the real world, the S corporation structure is popular among businesses that aim to retain earnings for growth without immediate double taxation, yet still wish to operate with the formal structure and legal protections of a corporation. The U.S. Small Business Administration (SBA) recognizes the S corp as a distinct business structure, highlighting its design to avoid the double taxation drawback associated with regular C corporations.30 This makes S corporations a significant part of the U.S. business landscape, accounting for a large percentage of corporations with fewer than 500 employees.29

Limitations and Criticisms

Despite its advantages, the S corporation structure comes with specific limitations and has faced some criticisms. One significant restriction is the limit on the number and type of shareholders. An S corporation cannot have more than 100 shareholders, and shareholders must generally be U.S. citizens or residents, or certain trusts and estates. Partnerships and corporations are typically not permitted to be S corporation shareholders. Additionally, an S corporation is limited to having only one class of stock, though differences in voting rights are generally allowed.28,27,26 These limitations can restrict a business's ability to raise equity financing from a broad range of investors, such as venture capital firms, which often prefer the flexibility of C corporations with multiple classes of stock.25

Another area of scrutiny revolves around the "reasonable salary" requirement for shareholder-employees. The IRS mandates that owners who work for the S corporation must be paid a reasonable salary for their services, which is subject to payroll taxes. If the salary is deemed too low compared to industry standards, the IRS may reclassify distributions as wages, leading to additional tax liabilities. This requirement necessitates careful compliance and often professional tax advice to avoid potential issues.24

While S corporations avoid federal corporate income tax, they may still be subject to certain entity-level taxes in some states. Some states do not recognize the S corporation election and tax them as C corporations, or levy a tax on profits above a certain limit.23,22 Furthermore, converting from a C corporation to an S corporation can sometimes trigger a "built-in gains" tax on assets held prior to the S election, which can be a significant penalty if those assets are sold within a certain timeframe.21

S Corporation vs. C Corporation

The primary distinction between an S corporation and a C corporation lies in their federal income tax treatment.

FeatureS CorporationC Corporation
Federal TaxationPass-through taxation; income/losses reported on shareholder's personal returns.Double taxation; company pays corporate income tax, then dividends are taxed at shareholder level.20
Shareholder LimitMaximum of 100 shareholders.19Unlimited shareholders.18
Shareholder TypeRestricted to individuals, certain trusts, and estates (U.S. citizens/residents).17No restrictions on who can be a shareholder.16
Classes of StockOnly one class of stock allowed.15Multiple classes of stock allowed.14
Liability ProtectionOffers limited liability for owners.13Offers limited liability for owners.12
Forming EntityMust file articles of incorporation with state, then Form 2553 with IRS.Files articles of incorporation with state.11

While both provide limited liability to their owners, the fundamental difference in taxation often drives the choice between an S corporation and a C corporation. C corporations are typically favored by larger businesses seeking to raise significant equity financing from a wide array of investors or planning to go public, as they allow for an unlimited number and types of shareholders and multiple classes of stock.10 S corporations are generally preferred by smaller, closely held businesses that prioritize avoiding double taxation and benefiting from the tax efficiencies of pass-through income.9

FAQs

How does an S corporation avoid double taxation?

An S corporation avoids double taxation because its income, losses, deductions, and credits "pass through" directly to the shareholders' personal tax returns. The S corporation itself generally does not pay federal corporate income tax. Shareholders report their share of the business's profits or losses on their individual tax returns, and are taxed at their individual income tax rates.,8

What are the main requirements to qualify as an S corporation?

To qualify for S corporation status with the U.S. Internal Revenue Service (IRS), a corporation must meet several requirements. It must be a domestic corporation, have no more than 100 shareholders, and only have allowable shareholders (typically individuals, certain trusts, and estates). It can only have one class of stock, although different voting rights among shares are permitted.7,6

How do S corporations pay owners, and what are the tax implications?

S corporation owners who also work for the business are typically paid in two ways: a "reasonable salary" and distributions. The salary portion is subject to payroll taxes, including self-employment tax (Social Security and Medicare contributions). The distributions, which are the remaining profits paid out after salary and other expenses, are generally not subject to self-employment tax. This structure can lead to tax savings compared to other business forms where all net income is subject to self-employment tax.5,

Is an LLC the same as an S corporation?

No, an limited liability company (LLC) is not the same as an S corporation. An LLC is a legal business entity structure that provides limited liability protection to its owners. For tax purposes, an LLC is typically taxed as a sole proprietorship (if it has one owner) or a partnership (if it has multiple owners) by default. However, an LLC can elect to be taxed as an S corporation by filing Form 2553 with the IRS, provided it meets the S corporation eligibility criteria.4, This election changes the tax treatment, not the underlying legal structure.

What is IRS Form 2553 and when is it filed?

IRS Form 2553, officially titled "Election by a Small Business Corporation," is the form a corporation or an eligible entity (like an LLC) files with the U.S. Internal Revenue Service (IRS) to elect S corporation tax status.3 It must be signed by all shareholders. The form is generally filed no more than two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the preceding tax year.2,1