An S corp is a type of small business corporation that allows shareholders to report its income and losses on their personal tax returns at their individual income tax rates, while also limiting their liability.
An S corporation, also known as an S subchapter, is a way for shareholders to avoid double taxation on corporate income. In addition to tax benefits, it also provides limited liability protection and asset protection for S corporation shareholders.
S corps are treated the same as a regular C corporation in terms of business structure, the main difference is how they pay business taxes. With a C corp, the business pays taxes on income, plus the shareholders also pay taxes on any profits they receive from the business.
With S corps, instead of the corporation and shareholders each paying taxes, shareholders are allowed to pass the corporate income, losses, deductions, and credits through to their own personal income taxes, paid at each shareholder’s income tax rate. S corporations are still responsible for paying taxes on certain gains and income.
S corporation status also provides liability protection for their investors. Ordinarily, an investor or partner in a small business could be responsible for any debts or liabilities it accrues, putting their personal assets at risk. As a business entity, an S corp generally protects shareholders from such obligations.
To qualify for S corp status, a business owner must file articles of incorporation with the Secretary of State in the state where their business is located. Many states require S corps to pay annual fees and a franchise tax, which could be deducted from the S corp’s operating expenses.
An S corp must also file an application with the Internal Revenue Service and meet certain IRS qualifications for federal tax purposes within the internal revenue code. They must be a United States corporation, without foreign partnerships or non-resident alien shareholders. They can have no more than 100 shareholders and issue only one class of stock. Partnerships and corporations are not allowed to be shareholders.
Company employees are allowed to be shareholders and draw a reasonable salary, but there are restrictions in how much an employee can receive in salary versus dividends from business income.
There are times when S corp tax advantages are nullified. Depending on their income tax status, some shareholders could wind up paying more on their individual tax returns if their personal income tax rate is larger than the corporate tax rate.
Having S corp income included on their personal tax returns could also push some shareholders into a higher income tax bracket. That could lead to paying more in taxes.
A limited liability company (LLC) and an S corp are often used by many small business owners for their legal and financial advantages. While each allow the pass-through income of company profits, and provide some liability protection for owners or shareholders, there are differences between the two.
LLCs are easier to create and don’t have to abide by IRS restrictions on the number and types of shareholders or members. LLCs are often formed as a sole proprietorship or single-member LLC, or as a partnership. Almost any type of business can become an LLC, from attorneys and accountants to landscapers and professional cleaners. In addition, LLC owners face no restrictions in how to divvy up their profits.
While S corps require more paperwork and restrictions, they have advantages in terms of financing. S corps can sell shares to investors, whereas LLCs typically rely on bank loans. S corps also have to report their earnings and file tax returns with the federal government, even though they are largely exempt from corporate income taxes.
While an S corp can protect you from personal liability as a business owner, a liability lawsuit can still take a toll on the finances of your small business. Having the right insurance policies in place can help reduce your risk of taking a large financial hit in the event that a client, customer, or another third party files a liability lawsuit against you.
These key policies can help cover the legal expenses of potential liability lawsuits:
Errors and omissions insurance (E&O). Also referred to as professional liability insurance, an E&O policy covers the cost of lawsuits filed by a client or customer accusing your S corp of a work error or oversight. These lawsuits may include disputes over quality of work or the details of a work contract you signed with a client.
General liability insurance. This policy protects your S corp against lawsuits from third parties, such as a customer or client, over bodily injury, property damage, or advertising injury. Some property owners may require that you carry this policy if you rent your office. A business owner’s policy (BOP) bundles general liability and commercial property insurance at a discount; typically low-risk small businesses are eligible for a BOP.
Workers' compensation insurance. State law usually requires that corporations carry this policy for any employees they may have. This policy covers medical expenses and lost wages when an employee is injured on the job. It's a good idea to carry workers' comp even when it's not required, as health insurance can exclude coverage for work-related injuries.
Cyber liability insurance. First-party cyber liability coverage can help your S corp bounce back following a cyberattack. This policy can cover ransom payments, customer notification, and other related costs from such a breach. Third-party cyber liability insurance, on the other hand, covers legal costs in the event that you're held responsible for a client's data breach. Many insurance providers will include both first-party and third-party cyber liability insurance in a package called technology E&O insurance to protect your S corp in any situation.