What is an S Corporation

Denise Elizabeth P
Senior Financial Editor & Contributor

If you’re a business owner and are considering opening a new business, one of the first things you’ll need to decide is what type of entity you want to run.

The most common entity options are C Corporations, Limited Liability Company, Sole Proprietorship, Partnership, S Corporations, and non-profits.

One option that tends to confuse business owners or that many don’t quite understand is an S corporation, or “S corp” for short.

Today we are going to dive into the world of the S Corporation business structure so you can learn everything there is to know about this business election.

What is an S Corporation?

According to the Internal Revenue Service “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.”

Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates rather than at a corporate tax rate.

However, there are certain qualifications that need to be met in order to be approved for an S corporation status:

  • Must be a domestic corporation
  • Allowable shareholders – individuals, certain trusts, and estates and may not be partnerships, corporations, or non-resident alien shareholders.
  • Cannot have more than 100 shareholders and only one class of stock
  • Certain business types such as financial institutions, insurance companies, and domestic international sales corporations are not eligible for an S corporation election.

S Corporation Advantages


Liability Protection

Much like an LLC, an S corporation provides liability protection for the personal assets of its shareholders.

So long as there isn’t a personal guarantee, a shareholder does not have personal liability for the business debts and liabilities of the corporation.

In other words, creditors cannot pursue the personal assets (house, bank accounts, etc.) of the shareholders to pay business debts.

Pass-through taxation

An S corporation does not pay federal taxes at the corporate level.

Any business income or loss is “passed through” to shareholders who report it on their personal income tax returns.

This means that business losses can offset other income on the shareholders’ tax returns to reduce income tax paid.

This can be extremely helpful in the startup phase of a new business.

Tax-favorable characterization of income

Shareholders of an S corporation can draw “reasonable” salaries as employees of the business.

They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation.

A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.

Easy transfer of ownership

Interests in an S corporation can be freely transferred without triggering adverse tax consequences.

The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.

Easier accounting

Unlike Corporations, an S Corporation can use the cash method of accounting.

Corporations must use the accrual method of accounting unless they have gross receipts of $5,000,000 or less.

S corporations, can use the cash method of accounting unless they have inventory.

S Corporation Disadvantages

Expensive Formation and maintenance

Setting up a Corporation or S corporation is more expensive and more involved than setting up a sole proprietorship or general partnership.

S corporations are required to first incorporate the business by filing Articles of Incorporation with the desired state of incorporation, obtain a registered agent for the company, and pay the appropriate fees.

Many states also require ongoing fees and annual reporting requirements as well as franchise tax fees.

Reporting errors and tax errors

In rare cases, mistakes regarding the various election, consent, notification, stock ownership and filing requirements can accidentally result in the termination of S corporation status.

Stock restrictions

S corporations can only have one class of stock and no more than 100 shareholders.

Also, foreign ownership is prohibited completely.

Increased IRS scrutiny

Because amounts distributed to a shareholder can be dividends or salary, the IRS scrutinizes payments to make sure the characterization conforms to reality.

As a result, wages may be re-characterized as dividends, costing the corporation a deduction for compensation paid.

Conversely, dividends may be re-characterized as wages, which subjects the corporation to employment tax liability.

Less flexibility in allocating income and loss

Because of the one-class-of-stock restriction, an S corporation cannot easily allocate losses or income to specific shareholders.

Allocation of income and loss is governed by stock ownership, unlike a partnership or LLC where the allocation can be set in the operating agreement.

Also, the necessary accumulated adjustment account can be cumbersome to maintain, requiring input from an accounting professional.

Taxable fringe benefits

Most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2 percent of the corporation.

Forming an S Corporation

If you don’t already have a business name, you will want to create one.

There are some business naming resources that you can use like Domain Name Search from MyCompany Works.

If you plan on doing business under a different name (something other than your registered business name), you will nee to complete a “Doing Business As” registration.

Each sate has its own rules regarding business names, but there are a few key things to consider when choosing or editing your business name:

  • Your business name must be different than any other registered business entity.
  • You cannot use certain words like bank (unless you are a financial institution), or FBI (words that can be confused with a government agency), etc.
  • The name must end with “Incorporated”, “Company”, “Corporation”, “LLC”, etc. so that it is known that your company is incorporated.

Articles of Incorporation

The Articles of Incorporation are what officially registers your corporation.

Although all articles generally require the same basic information, requirements may vary slightly from state to state.

You will need the following information to complete your articles:

  • Full names, addresses, and contact information for all business owners – the business owners of a corporation are known as the shareholders and they own shares of stock in the business.
  • Full names, addresses, and contact information for all decision-makers – these are called incorporators and directors
  • Business name
  • Address of the corporation – if your business has multiple addresses, you will need to choose one that will be your official mailing address.
  • Physical address in State of Formation
  • Length of time the company has been in business or has existed
  • Registered agent information (learn more about registered agent here).
  • Description of company’s business
  • Information about the new corporation – mission statement and explanation of purpose

Obtain an EIN (Employer Identification Number

Corporations, LLC’s, Partnerships, and Sole Proprietorships with employees are all required to apply for a Federal Employer Identification Number (FEIN).

You will need this to open a business bank account or process payroll.

If you use an incorporating service to setup your business entity, they make it easy and will obtain an EIN for you when your business is formed.

You can also do so by preparing and submitting an IRS Form SS-4.

Apply for Business Licenses

  • Federal Permits – most businesses do not require a Federal license or permit, however you should double check to make sure you won’t need one.
  • State Licenses – building contractors, banks, insurance carriers, physicians, real estate agents, barbers, cosmetologists, are just a few of the occupations that require a state license. You will want to contact your state agency to find out what license requirements there are for your specific occupation.
  • State Licenses by Product – liquor, lottery tickets, gasoline, and firearms are examples of products that require specific licensing.
  • Sales Tax Permit – if your company will be selling physical products, you may be required to collect a State Seller’s Permit or Resale Permit.
  • Business License – the majority of Cities and Counties will require you to obtain a business license, even if you have a home-based business. This license grants your company the authority to do business in that city or county.

Corporate By-Laws

Bylaws need to summarize company rules surrounding operations, officer positions, and duties.

In some cases, bylaws are not required by the state, but it is highly beneficial to create and maintain bylaws for your own records.

Meeting Minutes

Minutes allow you to record and formalize decisions made during meetings, including but not limited to the appointment of board members, officers, and other relevant resolutions.

S Corporation in LLC

To take advantages of the structural benefits of an LLC combined with the taxation benefits of an S Corp, you can establish your business entity as an LLC and then make the election to have it treated as an S corporation by the IRS for income tax purposes.

The main reason to prefer S corporation tax treatment over partnership treatment has to do with employment taxes.

Under the Code, an owner of a business taxed as a partnership-who is employed by the business-is considered an owner.

An owner of an entity taxed as an S corporation who works for the business is considered an employee.

With an entity taxed as an S corporation, only the wages paid to its owner/employees are earned income subject to FICA tax for Social Security and Medicare.

Other net earnings that pass-through to the owners are considered dividend income.

This means those payments are not subject to SECA tax-provided the owner materially participates in the business-and they are not considered passive income.

Thus, an LLC taxed as an S corporation can do some tax planning that cannot be accomplished in an LLC taxed as a partnership or disregarded as an entity.

How is it Taxed?

S-corporations, like partnerships, are pass-through entities.

That is, there is no federal income tax imposed at the corporate level.

Instead, an S-corporation’s profit is allocated to its shareholder(s) and taxed at the shareholder level (personally).

S Corporations may be liable for Income Tax, Estimated Tax, Employment Taxes, and Excise Tax.

If you are an S corporation shareholder, then you may be personally liable for Income Tax and Estimated Tax.

The biggest tax benefit of an S corporation is that shareholders do not have to pay self-employment tax on their share of the business’s profits.

Each owner takes a “reasonable” salary that is subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation.

As a result, the savings from paying no self-employment tax on the profits only kick in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”


Jeff is the sole owner of his S-corporation, a marketing agency.

His revenues from the business are $70,000 per year, and his annual expenses (not counting salary) equal $20,000.

This makes his S-corporations profit for the year be $50,000 ($70,000 – $20,000 = $50,000).

Jeff pays himself a salary of $40,000, and counts the remaining $10,000 as profit, thus saving money as a result of not having to pay self-employment tax on the $10,000 profit.

Another example

Denise forms an S-corporation and contributes $40,000 cash to the business.

In the calendar year in which the business is formed, the business pays Denise a salary of $30,000, after which it has remaining ordinary business income of $20,000.

During the year, the corporation also makes a distribution to Denise of $25,000.

When Denise forms the corporation, her cost basis in the business is $40,000 (the amount she contributed).

The $20,000 ordinary business income increases her basis to $60,000, and the $25,000 distribution reduces her basis to $35,000.

$35,000 is her cost basis at the end of the first year.

The $30,000 salary will be taxable to Denise as ordinary income, and it will be subject to normal payroll taxes as well.

The $20,000 ordinary business income will be taxable to Denise as ordinary income, but it will not be subject to payroll taxes or self-employment tax.

The $25,000 distribution will not be taxable to Denise at all, because her cost basis before the distribution was greater than $25,000.

Key Takeaways

  • S-corporations, like partnerships, are pass-through entities.That is, there is no federal income tax imposed at the corporate level. Instead, an S-corporation’s profit is allocated to its shareholder(s) and taxed at the shareholder level (personally).
  • S-corporation annual tax returns are filed using the Form 1120s
  • Shareholders must receive a “reasonable” amount of compensation before they are exempt from paying self-employment tax on their share of an S-corp’s profits.
  • S-corporation taxation is similar to partnership taxation in that owners are taxed upon their share of the business’s income, regardless of whether or not it is actually distributed to them.
  • Distributions from the business are not taxable so long as they are not in excess of the shareholder’s basis in the S-corporation.

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  1. IRS.gov "S Corporations" Page 1 . April 7, 2021

  2. IRS.gov "Tax Informatio on S Corporations" Page 1. April 7, 2021

  3. SBA.gov "Choose a Business Structure" Page 1. April 7, 2021