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.