Many small business owners choose to incorporate their business. Corporate business entities come with tax advantages and liability protections. Should you decide to set up a corporation, however, you’ll need to choose between an S-corporation and a C-corporation.
Although a C-corp is the default type of corporation, S-corps can be a great option for small businesses—offering many of the advantages of a corporation with additional tax flexibility. Is an S-corp right for you?
Here, we’ll review everything you need to know about the S-corporation—including how to form one—so you can decide what’s best for your business.
The Ultimate Guide to S-Corps
What Is an S-Corp?
An S-corporation is an incorporated business that’s organized under Subchapter S of the IRS tax code. Therefore, whereas a C-corp or LLC is a distinct entity type, it’s perhaps more accurate to say that an S-corp is a specific tax status. This being said, with the status of an S-corp, corporations elect to be taxed as pass-through entities—meaning their shareholders report business income and losses on their personal tax returns.
With this in mind, to get a better sense of the makeup of an S-corp, let’s break down this business structure by looking at four overarching categories—management structure, liability protection, tax treatment, and regulations.
Management structure: Like a C-corp, an S-corp is owned by shareholders who hold stock in the company. The shareholders elect a board of directors to make strategic decisions on behalf of the corporation. And on a day-to-day basis, the company is managed by board-appointed officers—such as the chief executive officer and chief financial officer.
Additionally, although it’s common to have multiple people occupy each role in the management structure, most states also recognize one-person S-corporations. In that case, the sole owner acts as a shareholder, officer, and board member.
Liability protection: All corporations, including S-corporations, are considered separate legal entities from the owners. This means an S-corp offers owners limited liability protection.
If someone sues your business, they are limited to collecting on the company’s assets. Likewise, if you borrow money in your business’s name, the creditor can only recover the debt out of your business’s assets (unless you’ve personally guaranteed the loan, in which case you are personally responsible for repayment).
Tax treatment: Perhaps the biggest difference between an S-corp and standard corporation is taxation. Whereas C-corporations pay a corporate-level income tax, S-corporations are pass-through entities. As we mentioned above, this means shareholders in an S-corp report business income, expenses, losses, and deductions on their personal tax return and pay taxes at their personal income tax rate.
Additionally, with the passage of the Tax Cuts and Jobs Act—more popularly known as the Trump Tax Plan—most S-corps can claim a 20% deduction of business income on their tax returns.
This being said, instead of filing IRS Form 1120, S-corps file Form 1120-S to show the business’s income and losses for informational purposes. In addition to Form 1120-S, S-corporations are also responsible for providing each shareholder with a Schedule K-1 and filing these forms with the business’s return. Each shareholder then uses the information on their Schedule K-1 to file their personal Form 1040 return.
Consult our comprehensive guide to business taxes to learn more about how S-corps are taxed.
Regulations: Finally, like C-corps, S-corps must observe corporate formalities, such as adopting bylaws, holding shareholder meetings, and filing annual reports. One of the most significant formalities, of course, is issuing stock.
Along with C-corporations, S-corporations are the only other type of business which lets you issue stock to shareholders. With this in mind, however, when it comes to shareholders and stock S-corps have limitations that C-corps do not.
C-corps can have an unlimited number of shareholders, whereas S-corps are limited to 100 shareholders and one class of stock—although different voting rights for shareholders are allowed. In addition, shareholders in S-corps must be U.S. citizens or resident individuals. With C-corps, on the other hand, resident aliens and companies are eligible to own stock in their companies.
Use our guide to compare S-corps vs. C-corps in more detail.
How Does an S-Corp Work?
So, with this information in mind, you might be wondering exactly how S-corps work. Unlike C-corporations, which are simply formed by incorporating with your state, S-corps require an additional step—electing S-corp status with the IRS.
This being said, however, an S-corp can actually be created in two ways (as we’ll discuss in greater detail below). First, you can start by registering your business with the state and forming a corporation. After you’ve established your corporation, you can then elect S-corp status.
On the other hand, you can start by registering your business with the state and creating an LLC—and later elect S-corp status.
In either case, however, you’ll have to abide by certain requirements to establish and operate your business as an S-corporation:
Although the requirements vary by state, here are the corporate formalities that an S-corp typically needs to comply with:
- Be based in the U.S.
- Adopt and comply with corporate bylaws
- Hold annual board of directors and shareholder meetings
- Hold special meetings to vote on important company decisions
- Keep meeting minutes
- File annual report
- Issue a bill of sale when selling new shares
- Limit shareholders to 100
- Limit shareholders to U.S. citizens and permanent residents
- Only have one class of stock
- Keep written documentation of company transactions and contracts
- Maintain a separate business bank account
- Pay a franchise tax (in some states)
You’ll want to keep in mind that you’ll need to follow these S-corp requirements even if you’re a single-owner corporation. For instance, you’ll need to hold meetings where you formally document and decide on company matters.
S-Corps vs. Other Entity Types
As we’ve mentioned, S-corps are not the only type of corporation, nor are they the only type of business structure. If you’d prefer to incorporate your business, of course, you’ll have to choose between C-corp and S-corp, but there are a variety of other entity types you might consider as well.
How does an S-corp compare to other entities like an LLC or sole proprietorship?
You can refer to the chart below to learn more.
How S-Corps Compare to Common Entity Types
|Type of Entity||Management Structure||Liability Protections||Tax Treatment||Regulations|
Incorporated business that is taxed as a pass-through entity
Taxed at personal tax rate of shareholders
High level of regulations, has restrictions that C-corps don’t have
Incorporated business composed of shareholders, directors, and officers
Must pay corporate taxes (but also taxes on dividends)
High-level of regulations, more flexibility with shareholders and issuing stock
Registered business with limited liability for all members
Members choose tax treatment; can be taxed as a corporation or pass-through entity; LLCs often pay more self-employment taxes than S-corps
More regulations than unincorporated businesses but fewer than C-corps or S-corps
Unincorporated business with one owner or jointly owned by a married couple
Taxed at owner’s personal tax rate
Very few regulations
Unincorporated business with two or more owners
Taxed at personal tax rate for each partner
Very few regulations
At this point, we’ve already reviewed some of the main similarities and differences between an S-corp and a C-corp—as you might notice, however, LLCs and S-corps are also fairly similar. In fact, as we mentioned, you can start your business as an LLC and later elect S-corp status.
This being said, overall, the biggest difference between an LLC in an S-corp is tax-related—if you elect S-corp status you can save money on self-employment taxes. In short, because a shareholder who actively works for the company is considered an employee (and not a business owner like with LLC members), only their salary is subject to self-employment taxes.
Compare all the differences between an LLC vs. S-corp using our comprehensive guide.
S-Corporation Pros and Cons
With all of this information in mind, you might have some sense of why businesses choose to create an S-corporation. To help you decide if an S-corp is right for your business, however, let’s break down the pros and cons of this status in more detail:
- Can issue stock to raise capital
- Limited liability protection for shareholders
- No corporate-level tax and no double taxation
- Can write off business losses on your personal income tax return
- Can save on payroll taxes
Ultimately, an S-corporation is a good choice of entity type if you want the advantages of a corporate structure along with pass-through taxation (as well as business tax deductions).
You can issue stock to raise money, and enjoy limited liability. At the same time, you don’t have to worry about a corporate level tax, and simply have to report your share of the business income and losses on your personal tax return.
On the other hand, there are disadvantages associated with forming an S-corp as well:
- Limited to 100 shareholders and one class of stock
- Difficult to raise venture capital (because of the shareholders and stock limitations)
- Have to comply with corporate formalities
- More time-consuming and expensive to start than other entity types
Although forming and maintaining an S-corp can be more involved and costly than starting a sole proprietorship or general partnership, for example, many businesses choose to do so because they find that the tax benefits outweigh the drawbacks.
How to Form an S-Corp
Now that you know what an S-corp is and the possible advantages of electing this tax status, let’s explain how to form an S-corp.
Although each state will slightly different requirements, you can follow these common steps to create an S-corporation:
- Register your business with the state as a C-corporation or LLC: Most businesses will file articles of incorporation with their state’s secretary of state or business filing agency to establish their business as a corporation. However, you might also choose to instead file articles of organization to form your business as an LLC.
- Apply for an Employer Identification Number: New corporations must apply for an EIN from the IRS.
- Ensure that you meet the S-corp requirements: As we listed above, in order to form an S-corp, your business needs to be operating in the U.S., have no more than 100 shareholders, and only have one class of stock.
- File Form 2553: Finally, to establish your C-corp or LLC as an S-corp, you’ll need to file Form 2553 (shown below) with the IRS.
Additionally, it’s important to note that a few states also require S-corps to adopt corporate bylaws at the outset.
For an established business that’s converting to an S-corp, Form 2553 is due no later than two months and 15 days after the start of the tax year—March 15. For a new business, Form 2553 is due no later than two months and 15 days after you start doing business. For instance, if you start doing business on June 1, your form is due no later than August 16 of the same year.
This being said, although you can incorporate your business and file for S-corp status on your own, many online legal services—like LegalZoom or IncFile—can work with you and file the appropriate forms on your behalf. Similarly, you might also opt to enlist the services of a business attorney to help you form an S-corporation.
The Bottom Line
At the end of the day, S-corporations are a popular type of business entity in the U.S., and with good reason. As we’ve discussed, S-corporations come with numerous structural and tax advantages. They offer limited liability protection and allow you to raise capital by issuing stock. At the same time, S-corps offer tax simplicity and advantages.
Of course, forming an S-corp won’t be right for every business, so if you’re still unsure whether or not the S-corp structure is well-suited for your needs, we’d recommend consulting a business attorney for their professional advice.