The term s corporation comes from

A Subchapter S corporation is a form of corporate organization under which the obligation to pay income taxes is passed through to the shareholders of the organization. The "Subchapter S" term comes from the segment of the United States Internal Revenue Code (Chapter 1, Subchapter S) in which the rules governing the formation and operation of Subchapter S corporations is located.

S Corporation Requirements

The Subchapter S type of organization is only allowed if an organization has 100 or fewer shareholders, is a domestic corporation (i.e., not foreign), only has one class of common stock, and only has certain types of eligible shareholders.

Advantages of an S Corporation

An S corporation is taxed as a partnership, which eliminates the double taxation associated with a shareholder dividend from which a normal corporation suffers, where the company is taxed on its income, and then its shareholders are taxed on their receipt of dividend income from the company. Instead, all earnings of the business are passed through to and recognized by the owners on their individual tax returns. An added advantage is that shareholders are protected from any liabilities incurred by the corporation.

Disadvantages of an S Corporation

A downside of the Subchapter S format is that the shareholders reporting the corporation's income on their tax returns must pay income taxes on those amounts, even if they have not received a distribution from the company. This means there can be considerable pressure for the company to regularly distribute cash to its shareholders, which may interfere with the formation of capital needed to grow the business. Thus, the S corporation structure may not work well for a business that requires a large investment in fixed assets and working capital.

Financial Reporting for an S Corporation

Because of the tax pass-through status of this type of organization, the business does not report an income tax expense on its income statement, nor does it report an income tax liability on its balance sheet.

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For businesses that qualify, electing “S-corp” status could lead to important tax benefits. When people casually refer to a corporation, they’re likely describing the most common and recognizable variety: a “C-corp,” which pays a corporate income tax and has an unlimited number of shareholders. But the “S-corp” designation means something else. Our guide outlines S-corps and describes how this designation compares to other business structures.

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S-Corp Defined

What Is a Corporation?

A corporation is a business entity that you form by filing incorporation documents with your state. Corporations differ from sole proprietorships, partnerships or LLCs in a variety of ways. A corporation has shareholders, directors and officers. The shareholders own stock in the company, the directors set policies and oversee the “big picture,” and the officers run the company day-to-day. In a small business, one person may serve in multiple roles.

As a legal entity, a corporation is distinct from its shareholders, meaning shareholders aren’t personally responsible for debts of the corporation (the shareholder liability is limited to shareholder investment). Corporations are also subject to a number of legal requirements to which other types of businesses are not. These include holding regular meetings and keeping corporate records.

What Is an S-Corp?

While a corporation is a type of business entity, an S-corp is a tax designation available to certain corporations and LLCs. S-corps are named from the subchapter of the Internal Revenue Code—subchapter “S”—under which the tax designation is spelled out. The most defining characteristic of an S-corp is its so-called “pass-through” tax structure.

Tax Structure

The IRS describes S-corps as corporations that, “pass corporate income, losses, deductions, and credits through to shareholders for federal tax purposes.” In other words, S-corps are exempt from a federal corporate income tax. Instead, income from dividends is taxed only at the individual level under whatever marginal income tax rate applies. (Marginal tax rates currently range from 10% to 37%.) This also means shareholders who meet certain criteria are able to offset corporate losses with income from other sources on personal income statements.

To contrast, C-corp shareholders are not allowed to write off corporate losses to offset other income on personal income statements. These shareholders still pay personal income tax on dividends taken home (at their own bracket’s marginal rate) but only after the whole of the corporation’s gains have been taxed at the corporate income tax rate (currently 21%). This arrangement is referred to as “double taxation” and has historically been viewed as the price to pay for a corporation’s limited liability advantages.

Liability Protection

Along with the tax advantages, S-corps still enjoy the same protection from liability offered by corporation status. Similarly, S-corps maintain an independent life from an owner—meaning the departure of key shareholders isn’t as big an obstacle to longevity as it might be for non-corporate business structures. This flexibility extends to relative ease in transferring ownership of the company, through either an outright or gradual sale. That said, most S-corps have some kind of transfer restriction that makes it harder for shareholders to exit than it would be for a C-corp.

S-corp taxation isn’t just for corporations—LLCs that meet eligibility requirements can also elect to be taxed as an S-corp. By default, LLCs are taxed like sole proprietorships or partnerships, meaning the owners are considered self-employed and pay self-employment tax on all business profits. S-corp shareholders can be company employees (rather than self-employed), reporting both a salary and distributions from company profits. S-corp shareholders only pay self-employment tax on the salary component of income, while distribution income isn’t subject to self-employment taxes.

Drawbacks

This all sounds great—so why doesn’t every business elect S-corp status? There are a number of stipulations to operate as an S-corp that may disqualify or disincentivize a business otherwise seeking the S-corp benefits. Perhaps most important are the strict limits around shareholders. S-corporations can’t exceed more than 100 shareholders, effectively ruling out corporations that want to go public.

S-corp ownership is restricted largely to individuals, who must also be citizens or permanent residents of the U.S., and to certain domestic trusts, estates and tax-exempt organizations. This rules out ownership from other corporations or partnerships, which are normally permitted to buy stock in a C-corp.

S-corps may receive extra scrutiny from the IRS, especially when it comes to the allocation of income between distribution and salary. Salaries paid to S-corp shareholders must be reasonable, and not artificially low to avoid taxes.

Is an S-Corp Right for Me?

While there’s no substitute for advice from licensed tax and legal professionals, an overview of the pros and cons can help point a business in the right direction.

Alternatives To Consider

Although they have many desirable characteristics, S-corps are only one of many possible business structure designations. As always, the right choice depends on the specifics of the business. Here are some of the other most common options:

C-Corp

C-corps are the most common type of corporation—essentially the default variety—and like S-corps, the structure gets its name from the subchapter of the Internal Revenue Code under which the classification is designated. While S-corps and C-corps are usually not any different under state corporation laws, the important differences lie in federal taxation.

With a C-corp, a corporate income tax is paid first with a federal return (Form 1120) required by the IRS. Shareholders must then pay taxes on personal income at the individual level for any gains from dividends. In exchange for this less favorable double taxation, C-corps enjoy an absence of restrictions on who can own shares. Unlike S-corps, C-corps can have an unlimited number of shareholders and can include businesses and entities both inside and outside the United States.

LLC

A limited liability company balances the relative ease and flexibility of a partnership structure with the increased risk protection and tax advantages of a corporate structure. LLC owners (known as “members”) aren’t personally liable for business obligations. By default, members pay taxes in the same way owners of a sole proprietorship or general partnership might. But an LLC can also elect to be taxed as an S-corp or a C-corp if it meets certain requirements. Many small business owners choose LLCs for simplicity and flexibility and eventually elect S-corp status rather than first registering as a corporation.

In order to establish an LLC, instead of filing Articles of Incorporation like a corporation, LLC founders must file Articles of Organization with whatever state agency manages business registration. Just like a corporation, an LLC must also list a registered agent.

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Sole Proprietorship

If a legal distinction between business and owner—and the protections this legal separation of entity can afford—are not important or desirable to a business founder, a sole proprietorship could be an appropriate alternative, given other specific circumstances. Sole proprietorship is the simplest structure for a one-owner business, giving the owner few regulatory burdens and a high degree of control and flexibility.

Without a distinct business entity, however, there’s no legal difference between the business’s assets, debts and other liabilities and those of the owner. Unlike a corporation, this means the owner is directly on the hook for any legal or financial failures of the business.

Partnership

Partnerships are similar to sole proprietorships on issues of liability and taxes. A partner of a general partnership, like a sole proprietor, reports his or her (or its) share of income, expenses, credits, profits and losses on personal tax returns, thus paying a personal income tax rate and assuming the business’s liability as personal liability.

Also similar to sole proprietors, partners must pay a self-employment tax, where applicable, on all gains without the benefit of separately categorized distributions that may go untaxed. A limited partnership (LP) or limited liability partnership (LLP) may be considered depending on the industry and other specifics.

Bottom Line

There is no one best option among the possible business structures and tax treatments. The choice should be based on the specific situation of each business. Owners should consult with legal and tax professionals during the business formation process. No matter what, it’s important to have a basic understanding of one’s options and to remember many businesses evolve from one business structure to the next as they grow.

Frequently Asked Questions

How can I be sure my business is eligible for S-corp status?

The IRS offers all the fine print on eligibility in its Instructions for Form 2553. Before making any moves, business owners should seek out all relevant details about eligibility requirements and see how these stack up with the specifics of their businesses.

Why does the federal government offer S-corp status?

Until S-corp status was created in 1958 on the recommendation to Congress of President Eisenhower, businesses typically could only choose between either the protection from liability of a corporation or the single layer of taxation enjoyed by sole proprietors and partnerships.

Both parties in Congress at the time had shared concern over the tremendous wealth and power a small number of multinational corporations were consolidating. In an effort to help small businesses stay competitive, the Treasury proposed a solution that could give small, American businesses a leg up—at least until they reached a certain size.

Can my business transition from a C-corp to an S-corp? How?

S-corps often begin life as C-corps, as it’s the default designation of a newly formed corporation. Before setting out to elect S-corp status, review the IRS’s information on S-corp filing requirements and eligibility requirements and consult a tax or legal professional to make sure it’s the right choice for your business. Then, submit Form 2553. The IRS’s webpage about filing with Form 2553 contains the most up-to-date links to tax resources and other helpful information.

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