S Corporation (S Corp): Definition, Taxes, and How to File

What is an S Corporation?

An S corporation (S corp) is a corporate business structure that elects to be taxed under Subchapter S of the Internal Revenue Code. It combines the limited liability and formal structure of a corporation with pass-through taxation: the company’s income, losses, deductions, and credits flow through to shareholders, who report them on individual tax returns. This avoids federal corporate-level income tax on most earnings.

Key characteristics:
* Must be a domestic corporation.
* One class of stock only.
* No more than 100 shareholders.
* Shareholders must be U.S. individuals, certain trusts and estates, or qualifying tax‑exempt organizations. Partnerships, corporations, and nonresident aliens cannot be shareholders.

How an S Corp Works

Taxation
* S corps are pass-through entities: profits and losses pass through to shareholders and are taxed at individual rates, avoiding double taxation that affects C corporations.
* The corporation can still be liable at the corporate level for certain built‑in gains and some types of passive income.
* Shareholder-employees must receive a “reasonable” salary for services; distributions beyond salary are not subject to payroll (self-employment) tax.

Corporate form and formalities
* An S corp is legally a corporation under state law and must observe corporate formalities: board of directors, bylaws, shareholder meetings, and meeting minutes.
* It issues stock and provides limited liability protection to its owners.

How to Elect S Corp Status

1. Incorporate the business under state law.
2. File IRS Form 2553, Election by a Small Business Corporation, with shareholder consents. The IRS accepts the election only if all eligibility requirements are met.

Tax Filing Requirements

• S corps file Form 1120‑S (U.S. Income Tax Return for an S Corporation) annually to report items of income, deductions, and distributions.
• Shareholders receive Schedule K‑1 showing each person’s share of income, losses, and credits to report on individual returns.
• Form 1120‑S is due by the 15th day of the third month after the corporation’s fiscal year ends (generally March 15 for calendar-year filers). Extensions can be requested via Form 7004.

Advantages

• Pass-through taxation avoids federal corporate-level income tax on most earnings.
• Potential reduction in self-employment tax by splitting owner compensation between salary and distributions (subject to reasonable compensation rules).
• Limited liability protects owners’ personal assets from most business liabilities.
• Simpler federal tax reporting than a C corporation and potential credibility with customers and investors.
• Generally straightforward transfer of ownership interests.

Disadvantages and Risks

• Strict eligibility and ownership limits (number and type of shareholders) can hinder capital-raising and growth.
• Must comply with corporate formalities and state filing fees, which involve time and cost.
• IRS scrutiny over reasonable compensation to shareholder-employees—improper classification of salary as distributions can trigger audits and payroll tax assessments.
• Profit and loss allocations must follow ownership percentages; less flexibility than an LLC in allocating tax items.

S Corp vs. LLC

Similarities:
* Both can be treated as pass-through entities for tax purposes and offer limited liability protection.

Differences:
* LLCs are more flexible in ownership, profit-allocation, and governance (no required board, meetings, or single class of stock).
* S corps have stricter IRS rules on shareholder eligibility, number of shareholders, and one class of stock.
* LLCs may be simpler to operate for very small or closely held businesses; S corps can offer tax advantages in certain compensation structures.

Practical Use and When It Makes Sense

An S corp is often attractive for small businesses that want corporate liability protection while minimizing federal income tax at the entity level. It can be tax-efficient when owners are active in the business and can justify a reasonable salary with additional distributions. It is less suitable for businesses seeking wide or institutional equity financing or for owners who want flexible profit allocation arrangements.

Explain Like I’m Five

An S corp is a company that doesn’t pay federal income tax itself. Instead, the company’s money goes to the owners, and they pay income tax personally. This avoids taxing the same money twice and gives owners corporate protection if the business has legal or financial trouble.

Bottom Line

An S corporation is a common choice for small, closely held businesses that want liability protection and pass-through taxation. It offers tax benefits compared with C corporations but requires adherence to specific IRS rules, corporate formalities, and limits on ownership that can affect growth and financing options. Consider business goals, ownership plans, and tax implications (including reasonable compensation rules) when deciding between S corp, LLC, or C corp status, and consult a tax advisor or attorney for personalized guidance.