Corporations are a type of American business structure that is extremely useful for running a business with multiple shareholders, where transferring ownership is simple and the owners' personal liability is protected.
What few people know is that there are several types of corporations, and when we use the term "Corporation", we commonly mean C-type corporations. However, S-Corps are a different structure, with different obligations and different ways of being taxed and managed.
In this article, we will take an in-depth look at the "S-Corp" business structure so you know everything essential about it. Let's get started!
What is an S-Corp?
An S corporation is a tax designation available to certain corporations and LLCs. With S Corp recognition, a corporation is treated by the IRS as a pass-through entity (Pass-trough entity), which means that it does not pay corporate income tax; instead, its shareholders are responsible for paying the taxes owed.
S-Corp is only a tax status, and it does not change how corporations operate: they will still have shareholders, directors and officers, must hold regular board meetings, and liability is limited to the shareholders' investment, just like a C-Corp. The same applies to LLCs.
For context, the term S Corporation comes from "Small Business Corporation", which is why they are often associated with smaller businesses that want to obtain better tax conditions in order to grow faster.
What are the requirements to obtain the S-Corp designation?
According to the IRS, to obtain S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders (for example, they cannot be partnerships, corporations or non-resident alien shareholders)
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies and domestic international sales corporations).
Advantages and disadvantages of S-Corps
Here is a table comparing the advantages and disadvantages of S-Corps. We go into detail below so you understand how they work.
| Advantages | Disadvantages |
|---|---|
| No double taxation like C-corps have | Maximum limit of 100 shareholders |
| Corporate losses can be passed through to the owners | Strict requirements for its shareholders |
| Limited liability for directors, officers and shareholders | Harder to obtain equity financing than C-corps |
| Existence independent of the shareholders | Greater scrutiny from the IRS |
| Taxes are filed annually instead of quarterly. | Only one class of stock is allowed |
| Self-employment tax is lower for LLC owners |
The advantages of an S-Corp
- No double taxation: One of the main advantages of S-Corps is that they are pass-through entities. This means that, unlike traditional corporate status (C-Corp), they do not pay tax as a company. This can save the business significant amounts of money in taxes every year.
- Corporate losses can be passed through to the owners: Being taxed as a pass-through entity means that the company's profits, losses, deductions and credits flow through to the shareholders, who report them on their individual tax returns.
- Limited liability: In addition to the tax advantages, S-corps still enjoy the same liability protection offered by corporate status. Their shareholders are protected from personal liability for the corporation's debts or obligations.
- Existence independent of the shareholders: Shareholders can come and go, and the corporation will live on. Unlike LLCs, transferring ownership is very simple.
- Taxes are filed annually instead of quarterly: An S corporation must file its annual tax return by the 15th day of the third month following the end of the tax year. A C corporation that owes $500 or more in income tax has to make four estimated quarterly tax payments to the IRS.
- Lower self-employment taxes: LLCs can be treated as C-Corps for tax purposes (see our article on LLC taxes). As an LLC owner and US resident, you will have to pay taxes on all of your business's net profits, while an "S" type corporation will only pay taxes on the salary you receive from your company.
The disadvantages of an S-Corp
- 100-shareholder limit: To be an S-Corp, the IRS requires that there be no more than 100 shareholders. This means that beyond a certain size, the company can no longer take advantage of this status, and it makes it impossible for companies that want to go public. It also makes it harder to obtain equity financing than with C-corps.
- Strict requirements for its shareholders: Ownership of an S-corp is limited to individuals who are US citizens or permanent residents, certain domestic trusts, estates and nonprofit organizations. This prevents other corporations or partnerships from acquiring shares in a C-corp.
- Greater scrutiny from the IRS: S-corps may face an additional level of scrutiny from the IRS, especially regarding the split of income between distributions and salary. Salaries paid to S-corp shareholders must be reasonable and not set artificially low in order to avoid taxes.
- Only one class of stock is allowed: The SEC states (Code Sec. 1361(b)(1)(D) and (c)(5); Reg. §1.1361-1(l)) that an S Corporation may issue only a single class of stock. Although these shares may have different voting rights, it is a fundamental requirement that they grant identical rights to distributions of profits and the income generated (Code Section 1361(b)(1)(D) and (c)(5); Regulation §1.1361-1(l)).
How are S-Corps taxed?
As mentioned earlier, S-Corps receive different tax treatment from regular corporations, since they are exempt from corporate income tax. However, they must still report their earnings to the IRS and file tax returns (which is different from having to pay taxes).
S-Corps must file Form 1120-S, which is a tax return that reports the income, losses, dividends and other distributions the corporation has passed through to its shareholders. This form is accompanied by a Schedule K-1, which details the percentage of the company's shares held by each individual shareholder.
Form 1120-S must be filed once a year. It is due on the 15th day of the third month after the close of the tax year (generally March 15 for companies that follow a calendar year).
S-Corps can request a six-month extension to file their tax returns. To do so, they must file Form 7004 before the regular due date of their return.
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How to open an S-Corp?
To obtain the S-Corp tax designation, there are a series of steps to follow, which we describe in detail below.
1. Register your LLC or corporation
The first step to obtaining S-Corp status is to have a registered formal business structure. Multi-member LLCs, single-member LLCs and corporations can apply for the S-Corp designation. If you haven't registered your business yet, we recommend following these guides:
Whether you choose a corporation or an LLC, you will need to choose a state in which to form your business, file certain documents with the Secretary of State, get a registered agent and, in the case of corporations, comply with other rules such as appointing directors and partners, drafting bylaws, etc.
If you prefer to delegate this process to a professional service, feel free to check out our LLC formation services.
2. Get an EIN
An EIN is a unique nine-digit number that the IRS uses to identify businesses for tax purposes. It is a type of Federal Tax ID for businesses. The Secretary of State issues EINs and uses them on state tax forms. The EIN is basically the SSN for businesses.
You can apply for it free of charge on the IRS website.
3. Verify that your corporation or LLC meets the requirements
Your corporation or LLC must meet each of the requirements to apply for S status that we have already described in this article.
4. File the paperwork to request S-Corp status
Once you have completed the previous steps, you can file IRS Form 2553, Election by a Small Business Corporation, which is the S-Corp election form.
The form can be filed online or by mail.
It is also important to pay attention to when this form is filed: it must be filed within 75 days after your LLC or C corporation is formed, or no more than 75 days after the start of the tax year in which you want S-Corp status to apply. If your election is made after this deadline, it will be valid for the following year.
5. Stay compliant with the requirements
You don't need to renew your election to be taxed as an S-corp with the IRS every year, but you do need to make sure your LLC or Corporation continues to meet the requirements. If it doesn't, you will have to revert to C-corp status or the traditional LLC tax structure.
Written by
Ignacio Navarro
Ignacio Navarro is a Certified Public Accountant, founder of Start Companies and a specialist in U.S. companies for entrepreneurs, freelancers and digital businesses in Latin America. With training in international taxation and studies at UCEMA, he advises non-resident clients on forming and maintaining LLCs, opening bank accounts, invoicing, accounting and taxes. His experience combines tax strategy, compliance and practical vision for operating in the U.S. in a simple, organized and professional way.
