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What is an S corporation?

S corporations are corporations that make a special election with the IRS to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.

To qualify for S corporation status, the corporation must meet the following requirements:

Be a domestic (US) corporation

Have only allowable shareholders, including individuals, certain trusts, and estates and may NOT include partnerships, corporations or non-resident alien shareholders

Have no more than 100 shareholders, and all shareholders must consent in writing to the S corporation election

Have only one class of stock

Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

How is an S corporation incorporated?

To be considered an S corporation, a business must be first incorporated as a traditional C corporation in the state where it is headquartered. A C Corporation becomes an S Corporation only when, with the consent of all shareholders, special pass through tax treatment is sought by filing Form 2553 with the IRS in accordance with Subchapter S of the US Internal Revenue Code. When a valid S corporation election is made with the IRS for federal income tax purposes, most states will also honor that federal S election for state purposes. However, a few states require that you also file an S Corporation election with the state and some states do not extend the same S Corporation tax exemptions.

How is an S corporation different from C corporation?

What makes the S corporation different from a traditional C corporation is that profits and losses of an S corporation “pass through” to shareholders personally, similar to partners of partnership or members of an LLC. Consequently, in most states, the S corporation is not taxed itself. Only its shareholders are taxed. There is an important caveat, however: any shareholder who works for the company must pay him or herself "reasonable compensation." Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as "wages."

All states do not tax S corps equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. However, some states (like Massachusetts) tax S corps on profits above a specified limit. Other states don't recognize the S corporation election and treat the business as a C corporation with all of the tax ramifications. Some states (like New York and New Jersey) tax both the S corps profits and the shareholder's proportional shares of the profits.

What are the advantages of an S Corporation?

Limited Liability. The shareholders of a C Corporation have limited liability and are not personally responsible for the debts and actions of a corporation. Accordingly, shareholders’ personal assets are protected. Shareholders can generally only be held accountable for their investment in stock of the company.

Pass-through Taxation. An S corporation does not pay federal taxes at the corporate level. (Most—but not all—states follow the federal rules.) Any business income or loss is "passed through" to shareholders who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns. This can be extremely helpful in the startup phase of a new business.

Tax-favorable Characterization of Income. S corporation shareholders can be employees of the business and draw salaries as employees. Shareholders can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation. A reasonable and appropriate characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.

Straightforward Transfer of Ownership. Interests in an S corporation can be freely transferred without triggering adverse tax consequences. (In a partnership or an LLC, the transfer of more than a 50-percent interest can trigger the termination of the entity, unless otherwise provided in organization documents.) The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.

What are the disadvantages of an S corporation?

Termination of Status. Unlike other business entities, mistakes regarding the various elections, consent, notification, stock ownership and filing requirements can accidentally result in the termination of S corporation status.

Stock Ownership Restrictions. An S corporation can have only 100 shareholders. An S corporation can have only one class of stock, although it can have both voting and non-voting shares. Therefore, there cannot be different classes of investors who are entitled to different dividends or distribution rights. Also, there cannot be more than 100 shareholders. Foreign ownership of S corporations is prohibited, as is ownership by certain types of trusts and other entities.

Closer IRS Scrutiny. Because amounts distributed to a shareholder of an S corporation can be characterized either as dividends or salary, the IRS scrutinizes payments to make sure the characterizations are appropriate. As a result, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.

Less Flexibility in Allocating Income and Loss. Because of the one-class-of-stock restriction, an S corporation cannot easily allocate losses or income to specific shareholders. Allocation of income and loss is governed by stock ownership, unlike a partnership or LLC where the allocation can be set in the operating agreement.