What is an S Corporation?

Learn what makes an S Corporation unique, and how to set one up. Includes frequently asked questions about S Corporations.

Updated on January 24th, 2020

The SMB Guide is reader-supported. When you buy through links on our site, we may earn an affiliate commission. Learn more

An S Corporation is a corporate entity that meets the criteria of section 'S' of the Internal Revenue Code. S Corporations are generally pass-through entities, similar to partnerships, and therefore have no immediate tax liability. An S Corporation's revenue is only taxed once - when it is paid out to shareholders.

In order for a corporation to be classified as an S Corporation, it must meet the following criteria:

  • 100 shareholders or less.
  • All shareholders must be individuals.
  • All shareholders must be residents of the country.
  • Only one class of stock may be available.

Benefits of an S Corporation:

The most obvious benefit of structuring your business as an S Corporation is that the tax burden can be passed on to individual shareholders. Any profits or losses are reported on individual tax returns and are subject to the individual's tax rate, rather than taxing the corporation directly.

Having the option to structure your small business as an S Corporation gives you as a business owner the benefits of shifting legal liabilities to a business entity without having to be subject to corporate tax rates. It also makes it much easier to give employees a stake in the business through shares.

How to Create an S Corporation:

Your business entity must first be legally registered as a corporation before you can elect to become an S corporation. Once you are established as a corporation and meet all of the requirements of an S Corporation listed above, you can take the following steps:

1. Complete Form 2553.

IRS Form 2553 can be used to elect to turn your corporation into an S Corporation for tax purposes. Submitting the form to the IRS begins the process of turning your corporation into an S Corporation.

2. Submit the form at the start of the tax year.

Form 2553 must be submitted to the IRS either (1) within 75 days of forming your business entity, or (2) before March 15 of the business year following the one in which you would like your S Corp status to apply retroactively. The IRS allows corporations to elect their entities as S Corporations for up to 3 years and 75 days after the date which they desire their status change to be effective.

3. Wait for a response from the IRS.

If your form is accepted, you will receive a notice from the IRS within 60 days. Upon acceptance, your business entity will remain an S Corporation unless you revoke its status or the IRS deems it to be no longer valid.

FAQs:

What is the difference between an S Corporation and an LLC?

LLCs are generally taxed as either sole proprietorships or partnerships, but an S Corporation is a special tax designation that allows members to pay taxes on their individual tax returns. An LLC can elect to become an S Corporation and pay its members a salary.

Why would you choose an S Corporation?

S Corporations provide small businesses with several advantages. First of all, they offer pass-through taxation which allows corporations to avoid paying federal taxes. They also allow employees to be shareholders at the same time. Finally, S Corps allow business owners to protect their personal assets by shifting liability to the corporation.

How do you become an S Corporation?

To start the process of becoming an S Corporation, businesses need to file IRS Form 2553.

What is better - S Corp or LLC?

This may depend on your tax situation and preference. As noted above, S Corps do offer some tax advantages that may be helpful to your business. Electing to become an S Corporation may also give you more credibility as customers see that you believe in the value of your company.

What qualifies as an S Corporation?

Established corporations seeking S Corp status must meet the following requirements:

  • Have 100 shareholders or less.
  • All shareholders must be individuals.
  • All shareholders must be residents of the country.
  • Only one class of stock may be available.

How does an S Corporation pay taxes?

S Corporations pass their taxes along to shareholders, meaning that all profits and losses are passed onto them and shareholders' gains or losses are taxed at their marginal tax rate.

Do you have to pay yourself a salary in an S Corp?

Yes. With an S Corp, you can be both a shareholder and an employee. You can pay yourself a salary and pay income taxes on that salary as you would if you worked for another employer.

How much does it cost to set up an S Corporation?

There are no fees specifically associated with electing to become an S Corporation. However, to do so you already need to have an incorporated business. To incorporate your business, you will need to pay all applicable filing and legal fees in your state.

Can you sue an S Corporation?

An S Corporation can be sued because it is still a corporate entity. Shareholders in an S Corporation can still be subject to personal liability if the issue arises from their own misdeeds. If there is no evidence of fraud, the corporation will still protect the individual members from liability.