When starting or running a small business, choosing the right legal structure is crucial. For many entrepreneurs, the S corporation (S corp) offers an appealing blend of liability protection, tax advantages, and flexibility. But what exactly is an S corp, and how do you know if it’s the optimal choice for your venture?

In this guide, we’ll demystify the S corp from top to bottom. Whether you’re a new business owner or a seasoned pro considering a restructure, you’ll find all the information you need to make an informed decision. Let’s dive in!

1. What is an S Corporation?

• • A Special Tax Status: An S corp isn’t a separate business structure like an LLC or C corp, but rather an IRS tax election.
  • Pass-Through Taxation: S corps avoid double taxation by passing income, losses, deductions, and credits through to shareholders’ personal tax returns.
  • Separate Legal Entity: An S corp is a corporation first, providing limited liability protection to shield owners’ personal assets.
  • Small Business Oriented: S corps can have no more than 100 shareholders and are limited to one class of stock.
  • Domestic Ownership Required: All shareholders must be U.S. citizens, residents, certain trusts, or estates.

2. Advantages of an S Corporation

• • Pass-Through Taxation: Profits are taxed only once on shareholders’ personal returns, avoiding double taxation.
  • Self-Employment Tax Savings: Only salary is subject to payroll taxes, not the entire business profit.
  • Personal Asset Protection: Shareholders typically aren’t personally liable for corporate debts and liabilities.
  • Flexible Profit Distribution: Profits can be allocated differently than percentage ownership with all shareholders’ consent.
  • Heightened Credibility: Having “Inc.” or “Corp.” in your business name can convey greater legitimacy to some consumers and vendors.

3. Disadvantages of an S Corporation

• • Increased Formalities: S corps must hold regular board meetings, keep minutes, and maintain other corporate compliance formalities.
  • Shareholder Compensation Complexities: Owners must take “reasonable salaries” on which they pay payroll taxes, which can be subjective.
  • Ownership Restrictions: S corps can’t have more than 100 shareholders, non-resident aliens as owners, partnerships, or other corporations as shareholders.
  • Heightened IRS Scrutiny: S corps often face more stringent tax auditing due to the potential for abuse in owner compensation.
  • Less Flexibility in Profit Allocation: Unlike partnerships and LLCs, S corps must allocate profit and loss proportionately to ownership.

4. How to Form an S Corporation

• • Create a compliant corporation or LLC: First form a corporation or LLC based on your state’s rules, choosing a unique name and registered agent.
  • Hold an organizational meeting: Appoint directors, adopt bylaws, decide on share structure, and issue stock to shareholders.
  • Obtain EIN: Apply to the IRS for an employer identification number (EIN) for your business for tax, financial, and hiring purposes.
  • File IRS Form 2553: Submit Form 2553 electing S corp tax treatment, signed by all shareholders, by the 16th day of the 3rd month of your tax year.
  • Obtain licenses & permits: Get the required business licenses, permits, and zoning clearances to legally operate your S corp.

5. Maintaining S Corporation Status

• • Hold Annual Meetings: S corps must have at least one yearly meeting with shareholders and directors to elect board members, review financials, and address key issues.
  • Keep Detailed Records: Maintain organized corporate records including bylaws, meeting minutes, shareholder info, stock ledger, and financial data.
  • Separate Business Finances: Use dedicated business bank accounts and credit cards to avoid commingling company and personal funds.
  • Pay Reasonable Salaries: Pay active shareholders fair market value salaries on which to withhold payroll taxes to avoid IRS scrutiny.
  • File Applicable Tax Returns: S corps must file Form 1120S annually, and shareholders report their percentage of profit/loss on Schedule E with their 1040.

6. Tax Filing & Payment Requirements

• • • • Form 1120S: U.S.Income Tax Return for an S Corporation
        • Filed annually by March 15th (or 75 days after incorporation for new S corps)
        • Reports the S corp’s income, losses, deductions, and credits
        • Includes Schedule K-1 for each shareholder detailing their share of pass-through items
      • Form 1120S Schedule K-1: Shareholder’s Share of Income, Deductions, Credits, etc.
        • Prepared for each shareholder and filed with Form 1120S
        • Reports each owner’s proportionate share of the S corp’s taxable items
        • Used by shareholders to complete their individual Form 1040 tax returns
      • Form 1040 Schedule E: Supplemental Income and Loss
        • Used by each S corp shareholder to report their pass-through business income/loss
        • Income/loss from S corp K-1 flows to Part II of Schedule E
        • The net profit/loss is then reported on the shareholder’s Form 1040
      • Employment Tax Forms: 940, 941, W-2, W-3
        • S corps with employees must file quarterly Form 941 payroll tax returns
        • Form 940 is filed annually to report federal unemployment taxes
        • W-2 wage statements are provided to employees and submitted to IRS with Form W-3
      • Estimated Tax Payments
        • S corp owners pay quarterly estimated taxes on their share of business income
        • Payments are generally due 4/15, 6/15, 9/15 and 1/15
        • Underpaying or missing estimates can result in penalties and interest

      Example: John and Susan own an S corp 50/50. When preparing their Form 1120S, the CPA reports $150,000 in total income on page 1, then allocates $75,000 to each shareholder on their Schedule K-1s. John and Susan report their respective $75,000 allocations on Schedule E and then their 1040 returns.

      Key Takeaway: S corps must file an annual Form 1120S tax return, including a Schedule K-1 for each shareholder. The K-1 reports each owner’s share of taxable income and loss, which they then claim on their individual 1040 using Schedule E. The S corp itself doesn’t pay entity-level income tax, but must remit payroll taxes on shareholder-employee wages.

      FAQ: Can an S corp owner just take distributions rather than a salary to avoid payroll taxes? The IRS requires S corp shareholder-employees to take “reasonable compensation” as taxable W-2 wages before receiving distributions of profit. Skipping salary and taking only distributions is a big red flag that can trigger an audit and stiff penalties.

      7. Revoking S Corporation Status

      • • Voluntary Revocation: An S corp can choose to revoke its S election by filing a statement of revocation with the IRS, signed by shareholders owning more than 50% of outstanding stock.
        • Effective Date: A revocation is effective on the date specified in the statement if filed by the 15th day of the 3rd month of that tax year. Otherwise, it’s effective the following tax year.
        • Involuntary Termination: An S election terminates automatically if the corporation ceases to qualify as a small business corporation, such as by exceeding 100 shareholders.
        • C Corporation Default: When an S election is revoked or terminated, the business becomes a C corporation unless it files Form 8832 to be taxed as a partnership or disregarded entity.
        • 5-Year Waiting Period: Once its S status ends, a corporation generally must wait 5 tax years before re-electing S status unless the IRS consents to an earlier election.

      Example: After 5 years, Alex and Jen’s S corp has grown rapidly and attracted VC funding. Since the new investors aren’t all U.S. residents and citizens, their company no longer qualifies for S status. Their election is automatically terminated and the business becomes a C corp.

      Key Takeaway: S corporations can voluntarily revoke their S election by timely filing a revocation statement with majority shareholder consent. Their S status can also be involuntarily terminated if they violate any of the eligibility rules. In either case, the corporation becomes a C corp by default unless another entity classification is elected.

      FAQ: What happens to built-in gains if an S corp converts to a C corp? If a C corp holds appreciated assets from when it was an S corp, it must pay a 21% tax on the net unrealized built-in gains (NUBIGs) if the assets are sold within 5 years of the S corp conversion. This prevents C corps from avoiding the gain by switching from S status.

      Pros & Cons of S Corporations: Quick Reference Chart

      ✓ Advantages	✗ Disadvantages
      Pass-through taxation avoids double tax	Strict shareholder & ownership limitations
      Self-employment tax savings on distributions	Reasonable salary requirement invites IRS scrutiny
      Limited liability protects personal assets	Increased formalities, paperwork & deadlines
      Heightened credibility vs. sole prop/partnership	Less flexibility allocating income/loss vs. partnership
      Owners can be employees with tax-free fringe benefits	Harder to raise capital or attract investors

      Bottom Line

      

      A successful S corp requires careful tax planning, reasonable salary determinations, and diligent corporate governance. Work with experienced tax and legal pros to maximize the benefits and minimize the risks of electing S status.

      S corporations can offer the best of both worlds for many small businesses – the liability protection of a corporation with the tax simplicity of a partnership. However, they come with some unique complexities and drawbacks that don’t suit all business models.

      Weigh the advantages of pass-through taxation, self-employment tax savings and legal peace of mind against the disadvantages of ownership restrictions, heightened formalities and loss of flexibility. If you have a small group of U.S.-based owners and want to minimize taxes while shielding personal assets, an S corp could be an excellent fit.

      Be sure to adhere to reasonable compensation rules, hold regular board meetings, keep pristine records and make all tax filings to avoid jeopardizing your S election. When in doubt, consult an experienced business attorney and CPA to help you leverage all the benefits of your S corporation while sidestepping the hazards.

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      Disclaimer

      This article is for general informational and educational purposes only. It is not legal, tax, or financial advice, nor a substitute for individualized professional counsel. Every business situation is unique and laws vary by jurisdiction, so please consult an experienced attorney and CPA in your state for specific guidance on forming and operating your S corporation.