S Corporation Definition

What is an S corporation?

As we said, an S corp is a tax classification. The “S” refers to Subchapter S of the Internal Revenue Code. LLCs and C corporations (the default form of corporation) can apply to be taxed as an S corp if they meet the IRS’s criteria. 

To qualify for S corporation status, a corporation or LLC must meet the following requirements, which include having:

• Only U.S. shareholders (for a corporation) or members (owners of an LLC), which can be individuals, certain trusts, and estates
• No shareholders/members that are partnerships, corporations, or non-resident aliens. (However, an S corp can own other businesses.)
• No more than 100 shareholders/members
• Only one class of stock

An LLC or corporation needs to complete Form 2553 with the IRS to apply for S corporation status.

Note that the business owners of both LLCs and corporations have limited liability protection, meaning that the personal assets of the owners are usually protected from the liabilities and debts of the business. Filing as an S corp doesn’t change this.

S Corporation Benefits

If your circumstances are right, there are numerous advantages to filing as an S corp. First, let’s talk about the benefits for a C corporation.

Advantages of an S Corporation Over a C Corporation

Pass-Through Taxation

A primary disadvantage for traditional corporations is “double taxation.” When the corporation makes money, the IRS taxes those profits on the corporate level. But when those profits are ‌distributed to the individual owners (called “shareholders”) as dividends, they’re taxed a second time on the shareholders’ personal tax returns.

When a C corporation qualifies to be an S corp, though, those profits are only taxed at the individual level. The business itself isn’t taxed on them. This is called “pass-through taxation,” and it’s how sole proprietorships and general partnerships are taxed. LLCs are also taxed this way unless they choose to be taxed as a corporation.

We should add here that, since the 2017 Tax Cuts and Jobs Act, the corporate tax rate has been lowered to a flat 21%. That means the disadvantages of double taxation aren’t as severe as before. We highly recommend (and we say this often) that you consult with a qualified tax professional (a good accountant) so they can advise you about what would be best for your business and situation.

Writing Off Losses

Similar to the way business profits pass through to the owners of an S corp, so do the losses. Unlike the shareholders of a C corporation, S corp owners can write off the company’s losses on their personal income statements. 

This can help offset their income from other sources and can be helpful if the corporation loses money in the first couple of years. Still, make sure you’re aware of ​​the IRS’s shareholder loss limitations.

Qualified Business Income Deduction

Under the Tax Cuts and Jobs Act, S corp owners may be able to deduct up to 20% of their qualified business income. This deduction isn’t available to C corporation shareholders.

Qualified business income (QBI) is basically your share of the company’s profits, or, as the IRS puts it, “QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.” The IRS website has a detailed explanation as to what is and is not included in QBI.

Advantages of an S Corporation Over an LLC

Even though a traditional LLC already has pass-through taxation, it could still benefit from electing S corp status. It takes a bit of explanation, but it could mean substantial tax savings for some LLCs.

The members of a standard LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by the LLC. Being self-employed means paying self-employment taxes (the taxes earmarked for Social Security and Medicare, which add up to about 15.3%) on all profits they receive from the LLC. This is more than the taxes they’d pay when working for someone else because their employer would pay half of them.

When the members elect S corp status, though, they can be compensated in two ways, by receiving their share of the profits and by being paid as an employee. Once they do that, they only pay employment taxes on their salary and not the profits they receive. (Of course, this is only for the taxes that go toward Social Security and Medicare; LLC members still must pay income and other applicable taxes on their profits.) This can add up to quite a lot for certain profitable LLCs. To get a better idea, check out our page for calculating your S corp taxes.

One caveat to this is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $1 and avoid contributing anything to Social Security and Medicare. The IRS doesn’t give a precise definition, but it seems to consider “reasonable” to be something similar to what others in your field are earning for the same work.

S Corporation Disadvantages

Compared to a C Corporation

Before you write off C corporations as an option, note that S corps do have their drawbacks.

Limited Number of Shareholders

An S corp can’t have more than 100 shareholders, while a C corporation or LLC has no such restriction. That limitation could be an issue later if the corporation expands and goes public.

Limited Types of Shareholders

All S corp shareholders must be U.S. citizens, or certain trusts or estates. That could limit your ability to expand internationally. You also can’t have partnerships, corporations, or non-resident aliens as shareholders. C corporations don’t have these limitations.

Class of Stock

One way to attract investors for your corporation is to offer preferred stock. That’s fine for C corporations, but the IRS doesn’t allow it for S corps.

More IRS Scrutiny

The extra restrictions on an S corporation mean that the IRS watches them more closely to see if they’re in compliance. In other words, you’re more likely to get audited.

Compared to an LLC

Having an LLC with S corp status does have some drawbacks over the standard LLC:

More Filing Requirements

As we listed earlier, S corps must adhere to more regulations than a standard LLC or C corporation. All the members must be U.S. citizens (which can also include certain trusts and estates), and there can be no more than 100 of them. A traditional LLC doesn’t have these limitations.

More IRS Scrutiny

Because of the above restrictions, the IRS tends to monitor LLCs filing as S corps more closely. That could mean a greater chance of being audited, even if you follow the law to the letter. In fact, S corp owners may want to observe many of the same formalities that C corporations do (such as regular meetings and extensive record keeping), even if they’re not legally required to.

Additional Tax Form

An LLC filing as an S corp will have the added step of filing Form 1120S, U.S. Income Tax Return for an S Corporation, at tax time. 

Summary

Armed with this information about S corps, we hope you now have a better idea as to whether it’s the right business structure for your dream company. However, weighing tax advantages and disadvantages is best left to professionals, so talk to a tax professional before making a decision.