What is an S Corp?

A notebook reads "Choosing a Business Entity" with S Corps as a tab

When starting a business, one of the first things you’ll do is choose what entity type your business will be. An entity type will determine your tax rates, paperwork requirements, and more.

Deciding on your small business’s entity type or legal structure can be challenging and sometimes confusing. Still, it’s necessary to pick the right one for your business. There are several entity types: sole proprietorships, partnerships, limited liability companies (LLCs), and corporations.

Within corporations are C Corporations (C Corps) and S Corporations (S Corps). In the U.S., there are over 1.4 million small businesses registered as C Corps. But S Corps are even more commonplace. The Internal Revenue Service (IRS) estimates that there are over 5 million S Corps in the U.S.

While Congress established S Corps primarily to encourage small, family-run businesses, it’s not a one-size-fits-all legal structure for all small businesses. Both S Corps and C Corps have unique advantages and disadvantages.

In this segment, we’ll review what S Corps are, how they work, and how to create one.

What Is an S Corp?

An S Corporation is a type of corporate entity that meets specific requirements set by the IRS regarding corporate taxation. It gets its name from subchapter “S” of the IRS tax code.

Overview

Business owners often choose S Corps because of its tax advantages, as an S Corp is primarily a tax designation. However, small business owners should know that its tax designation affects several other factors, including funding, legal liability, structure, and governance requirements.

Consulting an attorney, accountant, or business consultant can help ensure you’re choosing the best type of corporate entity for your business.

Let’s look at how an S Corp affects other factors of your business and summarize the potential advantages and disadvantages.

Taxation and Tax Implications

In an S Corp, profits, deductions, losses, and other credits pass through individual shareholders. The profits are then reported on personal tax returns at a personal tax rate — rather than on a corporate tax return with a corporate tax rate.

Pass-through taxation means that S Corp businesses don’t pay Federal tax on profits. Individual shareholders pay income taxes. Depending on the state’s laws, however, it may be subject to state corporate tax.

An S Corp’s taxation has a significant amount in common with the taxation of LLCs and partnerships. For these legal structures, profits and losses pass through to individual members, and the entity is not taxed. These are known as “pass-through entities.” 

In a partnership, however, partners may be responsible for self-employment tax. In an S Corp status, owners do not have to pay self-employment taxes. Both LLC and S Corps have taxable income at the personal level. 

An S Corp also avoids one of a C Corporation’s most distinctive features: double taxation. A C Corp must pay taxes on its profits as an entity at a corporate rate. While “double taxation” may sound like C Corps pay more corporate taxes than other entities, but that’s not the case. “Double taxation” refers to the fact that both the company and individuals receiving income from it pay tax. Any money individuals receive from a C Corp, like salaries and dividends, is also taxed at an individual income tax rate.

Even though S Corps avoid taxes at the Federal level and double taxation, that doesn’t mean that an S Corp is the most advantageous legal structure for your business — or that you’ll automatically pay less in taxes. If you choose a C Corp, the prospective corporate tax rate can actually be lower than individual tax rates, depending on the tax bracket.

Your business entity choice will depend on many factors, including business income, losses, deductions and other credits, the number of shareholders, your other income, and more. Again, it’s a good idea to consult an accountant before settling on the best legal entity for your company.

Funding

An S Corp can offer more funding options than a sole proprietorship, a partnership, or an LLC. S Corps can, for example, issue stock. However, your number of possible shareholders is capped at 100. That’s considerably less flexible than the stock-issuance capabilities of a C Corp. With a C Corp business, you can have an unlimited amount of shareholders.

Additionally, S Corp shareholders must meet more eligibility requirements than C Corp shareholders. 

S Corps can also only issue one class of stock, whereas a C Corp can have several different classes. And in general, funding options for S Corps are far less flexible than those of a C Corp.

Let’s say you want to start your business debt-free with Rollovers for Business Startups (ROBS), also known as 401(K) Financing. ROBS allows you to finance your business with funds from a qualified retirement plan, such as 401(k)s and Individual Retirement Accounts (IRAs). Small business owners have far greater control in funding their business with ROBS. Other financing solutions, such as loans and stock, require approval.

If you’re looking to take advantage of this funding method, your business isn’t allowed to be an S Corp. Why? Only C Corps can meet the IRS rules on qualified employer securities (QES).

Sole proprietorships, partnerships, and LLCs don’t have stock. That means they can’t issue QES at all — and ROBS depends on a prohibited transaction exemption that a C Corp possesses and S Corps do not.

Structure and Governance Requirements

An S Corp must meet all Federal and state requirements regarding its structure and governance.

S Corp companies need a Board of Directors, officers, and bylaws. Shareholder meetings are also required if stock is issued. In addition, annual reports and financial results must be available with complete transparency and regularly produced.

These requirements are nearly the same as those a C Corp mandates. However, no other business structure has these structure and governance requirements.

If your business is small and requires a Board of Directors, yearly meetings and annual reports can be excessive — and demanding. That’s one of the reasons why an S Corp may not meet your business needs. And yet, requirements like these can also positively impact your small business.

First, Boards of Directors can provide a great deal of valuable advice for any business. Plus, they can effectively introduce and integrate you into the business community and leadership roles.

Second, small business owners can benefit from the filing requirements, which include detailed record-keeping and publishing annual financial reports. By fulfilling these legal obligations, you’ll know exactly how your business is doing. From organizing balance sheets to cash flow and income statements, you’ll know how your business delivers on projections and your business performance.

An S Corp exists independently of the owner, often legally known as “perpetual existence.” They will still exist if the owner retires or dies. If you want to pass a business on to your heirs or sell it, you can’t do it with an S Corp. But you can by choosing a C Corp entity.

Legal Liability

An S Corp grants all owners legal liability protection. The corporation, not individual owners, is financially liable in case of bankruptcies, lawsuits, and business debts. Litigants and creditors can’t pursue you for personal assets.

Each business entity has its advantages and disadvantages, depending on your situation. So, you’ll need to weigh these carefully to determine what makes the most sense for you — and your business.

Advantages

  • Some increased ability and flexibility in obtaining funding for business growth
  • Stock issuance, which isn’t available to LLCs, partnerships, or sole proprietors
    • Restricted to 100 shareholders
    • Only one class of stock allowed
  • Potentially advantageous taxation
    • No Federal tax on business profits, although state taxes may apply (depending on the state)
    • No double taxation, as C Corps have*
    • Pass-through of profits to owners, who file individual tax returns at personal rates
    • Protection from personal liability
    • A strong corporate structure, including a Board of Directors, bylaws, and annual meetings, allows for mentorship and community standing
    • Exists in perpetuity, in case of owner retirement or death

Disadvantages

  • Potential tax disadvantages, depending on multiple factors
  • Subject to numerous Federal and state requirements
  • Management structure and decision-making path must abide by bylaws and other requirements; those wanting a flexible structure and hands-on decision-making with no requirements might view this as a drawback

    * Note that “double taxation” doesn’t necessarily mean you’ll be paying more taxes than S Corps. See the Tax and Tax Implications section above.

How to Create One

Note that you can’t usually register initially as an S Corp. Why? Because an S Corp is a tax designation only. You can either incorporate first as a C Corp or start as an LLC, and then change to an S Corp. This is done by filing Form 2553, Election by a Small Business Corporation, with the IRS.

To create a C Corp, you first need to consult the Secretary of State of your individual state to find specific requirements. Usually, the minimum requirements are:

  • A business name
  • A filing fee
  • An employer identification number (EIN)
  • Notice of intent

You will also need to make a tax filing with the IRS officially. To qualify for S corporation status, you’ll have to meet certain IRS requirements

Creating a C Corp is complicated and time-consuming. Working with an attorney can make the process easier. You can also consult a third-party company specializing in business filing, like MyCorporation.

MyCorporation can help entrepreneurs prepare the paperwork and file for a C Corporation, register a trademark or file an EIN application, and fulfill any other specific requirements.

To create an LLC, you must also go through the Secretary of State in the state where you want the LLC to be. Here, too, you will need to know their requirements. A filing fee and EIN are usually required, along with Articles of Incorporation and an Operating Agreement.

You may also need or want other material, in both cases, such as trademark filing, licenses, and other requirements of your business or industry.

You should choose an S Corp if you…

  • Find that the tax advantages create a beneficial environment for the company and its owners
  • Can benefit from the required structure and governance
  • Want personal protection from any company liabilities
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