Takeaways
- S corporations are business structures for small to medium-sized businesses.
- S corporations are capped at 100 shareholders, which can limit fundraising.
- S corporations have pass-through status; the business doesn't pay income taxes.
- S corporation shareholders can be individuals, trusts, or estates, but not C corps.
- S corporations and Limited Liability Companies (LLCs) are some of the most common legal business structures for startups.
What Is an S Corporation?
An S Corporation is a legal business structure that the Internal Revenue Service (IRS) deems a pass-through entity. This means the business's profits and losses, credits, and deductions pass through to the shareholders' personal tax returns. This contrasts with a C corporation, a separate legal entity taxed on its own profits.
S corporations can be terrific business structures for small and medium-sized businesses because they limit your liability. The corporation is legally responsible for business debts and other obligations. LLCs also offer these advantages but aren't limited to the number of investors. Small companies might have limited growth prospects with an S Corporation because owners and shareholders are capped (more below).
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How an S Corporation Works
When to Make Your Election
Business owners must make the S Corporation election by the fifteenth day of the third month of the tax year. Once you make this election, your S Corporation status is effective for the current and subsequent tax years unless the election is terminated.
You can also make the S Corporation election any time before the tax year you want it to take effect.[2]
IRS Filing Requirements
S Corporations are required to file Form 1120-S with the IRS each year. This form reports on the S Corporation's income, expenses, and other financial information. The S Corporation's profits and losses are then allocated to the owners based on their ownership percentage. The owners report their share of the profits and losses on their tax returns.
S Corporation Nuances
Many business owners opt to elect S Corporations status for the tax advantages. However, it is critical to consider other S Corp nuances before deciding whether it is the best structure for your business:
- Per-Share Ownership Limit: S Corporations cannot have more than 100 shareholders. This limitation can be restrictive for businesses looking to raise capital from a large number of investors. (Read more about accredited investors).
- Nonresident Alien Shareholders: S Corporations cannot have nonresident alien shareholders. This can be a disadvantage for businesses with international operations or investors. (Read more about institutional investors).
- Passive Income Limitations: S Corporations are subject to passive income limitations. If an S Corporation generates substantial passive income, it may lose its S Corporation status. If you run a real estate business generating passive rental income, an S Corporation might not be your best structure. (Read more about REITs).
- Administrative Requirements: While S Corporations generally have fewer administrative requirements than C Corporations, they still need to comply with certain formalities, such as holding annual meetings and maintaining corporate records. (Read more about how a board of directors works).
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How to Form an S Corporation
The process of forming an S Corporation involves several sequenced steps. Here’s how to get started setting up your S Corporation:
1. Select a Business Name: Choose a business name and reserve it with your state's secretary of state. If you are starting an online business, you will need to search for website names with website hosting services like BlueHost or Godaddy to find the perfect website name.
2. File Articles of Incorporation: Once you establish your business name, you will file articles of incorporation with your state's secretary of state. The articles of incorporation will give you the legal paperwork you need to maintain your corporation. You can use services like RocketLawyer to streamline this process.
3. Get an EIN: After your business is incorporated, you will need to get an Employer Identification Number (EIN) from the IRS. Your EIN is a nine-digit business identification number that you will use to file your business forms and taxes.
4. File Form 2553: Once you have completed the above steps, you can file Form 2553 with the IRS to elect S Corporation status. Form 2553 is also known as “Election by a Small Business Corporation.” Electing S Corp status is not an automatic process and must be submitted and selected to qualify as an S Corp.
5. Maintain Eligibility: After establishing your S Corporation, you must meet and maintain the eligibility requirements for continued S Corporation status.
Here are some eligibility parameters you must maintain to keep S Corp status:
- Having no more than 100 shareholders
- Having only individuals, estates, or certain trusts as shareholders
- Having only one class of stock
- Investors cannot be another S Corporation or a C corporation
- Shareholders cannot be nonresident aliens
- S Corporation must operate domestically
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Pros of an S Corporation
There are several advantages to forming an S Corporation. Here are several points to consider:
- Pass-Through Entity: One of the main advantages of S Corp is the tax savings. S Corporations don't pay taxes on the business income it generates. Instead, it avoids double taxation because these profits "pass through" the entity directly to your income statements. Because an S Corporation is a pass-through entity, shareholders only pay taxes on their share of the business' profits based on their tax returns. (Read about when to set up a business bank account).
- Limited Liability: Another advantage of S Corporations is that they can help to protect your assets. S Corporations are separate legal entities, meaning that the business's debts and liabilities are not your responsibility as an owner. This liability protection shields owners' assets if the company is sued or goes bankrupt.
- Easy Management: S Corporations are much easier to manage and maintain than C corporations, especially for small to medium-sized businesses. They do not have the same complex corporate structures, filing requirements, and a deep bench of investors as C corporations, which can save time and money. Some publicly traded companies have thousands of institutional and retail investors.
Cons of an S Corporation
There are also some disadvantages to forming an S Corporation. Before you start your S Corporation, read through these:
- Investors Numbers Capped: One of the main disadvantages is that S Corporations are limited to 100 shareholders. This can be a problem for capital-intensive businesses that want to raise capital and expand their investor base consistently.
- Shareholder Limits: S Corporations cannot have nonresident aliens as shareholders. This can be a problem for businesses that want to do business with international customers or investors.
When to Choose an S Corporation
Choosing the best business entity can be tricky if you are starting your own business. Selecting the best legal entity structure can save you on taxes and provide operational flexibility.
If you aren't sure what structure is best for your short-term and long-term business needs, you should consult a financial advisor, tax professional, or attorney to help you determine which entity best suits your needs. They can help guide you through specific requirements and assess your overall business needs. Consulting with a tax professional can help you determine if an S Corporation is right for you.
Other Business Entities
While an S Corporation might not be the best fit for your business, there are plenty of other legal structures to consider, like:
Smart Summary
An S Corp is a business entity that offers tax advantages to its owners. It is a pass-through entity, meaning the business's profits and losses pass through to the owners' individual tax returns. S Corps are a mashup of the benefits of a corporation and a partnership. They are limited to 100 shareholders, so businesses that want explosive growth coupled with a capital-intensive business model tend to choose other structures. S Corps are pretty easy to set up and get your business started.
Want To Start a Business? Read More:
(1) Internal Revenue Service. S corporations. Last Accessed January 13, 2025.
(2) Internal Revenue Service. Instructions for Form 2553. Last Accessed January 13, 2025.
