Learn how S corp tax treatment may affect your business finances and your shareholders' personal finances.
- An S corporation (S corp) is a federal tax status that allows corporate income, losses, deductions, and credits to pass through to shareholders.
- Each shareholder declares their share of the profits or losses on their personal income tax return and is taxed according to their income bracket.
- Eligible businesses may elect S corp status as an alternative to C corp status to avoid the double taxation inherent in C corp status.
The federal tax treatment of your business may affect your profitability, growth potential, and personal income tax liability. Selecting S corporation status could help you avoid the double taxation that comes with a C corporation, but S corp isn’t suitable for all companies. Here's what to know about potential advantages, drawbacks, and how to know if it's right for your business.
What Is an S Corporation?
An S corp is a designated federal tax status that passes corporate income, losses, deductions, and credits through to the shareholders for federal income tax purposes.[1] Rather than the corporation paying federal income tax on its profits, the taxable activity passes through to the company’s shareholders, who report their shares on their individual tax returns.[2]
This allows businesses to organize as corporations while generally avoiding the double taxation that can apply to traditional C corporations.[3]
It's important to note that an S corp is not a separate business entity in the same way a corporation or limited liability company (LLC) is. It’s simply a federal tax classification. Any eligible corporation or LLC can elect to be taxed as an S corporation.[4]
IRS Eligibility Requirements for S Corps
To be eligible to claim S corp tax status, a business must meet certain IRS criteria, including:[1]
- Be a domestic company (created or organized in the U.S., under U.S. law or the law of any state of America)
- Have no more than 100 shareholders
- Be owned only by “allowable” shareholders (partnerships, corporations, and non-resident aliens are prohibited, though certain trusts and estates may be permitted)
- Issue only one class of stock
Furthermore, some types of corporations are ineligible, including certain financial institutions, insurance companies,and international sales corporations (even if they’re based domestically).[1]
How Does an S Corporation Work?
An S corp operates in accordance with the underlying business model (the corporation or LLC), but the S corp status changes how the business is treated with regard to federal income taxes.
How S Corps Serve as “Pass Through” Entities for Taxation
Instead of generally paying federal income tax at the corporate level, the S corp passes its income, losses, deductions, credits, and any other tax items through to its shareholders. Each shareholder then reports their share on their individual income tax return.
Shareholders in an S corp owe tax on their allocated share of the company’s income whether or not the company actually distributes that money to the shareholders. So shareholders may, for example, still owe income tax on business income that was retained to build their cash reserves.
This pass-through structure generally allows S corporations to avoid the double taxation that can occur with C corporations, in which profits may be taxed at the corporate level and then again when distributed to shareholders as dividends.
High-Level Compliance and Payroll Requirements for an S Corporation
S corp status comes with ongoing record keeping and tax filing responsibilities. The exact requirements depend on the company and where it operates, but common federal requirements include:[1]
- Form 1120-S. This is the federal income tax return form S corps submit annually to report the business’s income, losses, deductions, credits, and any other tax items.
- Schedule K-1. The company prepares this form for each shareholder to report that shareholder’s share of the S corp’s income, deductions, credits, and other tax items.
- Form 941. S corporations with employees file this form quarterly to report wages, federal income tax withholding, Social Security, and Medicare taxes.
- Form 940. S corporations subject to federal unemployment tax (FUTA) file Form 940 annually to report their FUTA tax liability.
Shareholders who perform services for the S corporation may also be considered employees.
S corps are required to pay “reasonable” compensation to shareholder-employees as wages before making non-wage distributions to them.[5] This is because wages are subject to employment taxes while non-wage distributions are generally not. Paying an unreasonably low salary, offset by high distributions, would unfairly lower the employment taxes on that employee.
There is no single IRS-approved formula for determining a reasonable salary. Factors may include the shareholder's duties, experience, time invested in the business, and market wages for comparable jobs.
How S Corp Status May Affect Financing for Small Businesses
S corp status generally doesn't restrict a company's ability to borrow, although lenders may evaluate both the business's finances and the shareholders' personal finances when considering a business loan application.
Lenders may request information and documentation, including:
- Business and personal tax returns
- Form 1120-S and shareholders' Schedule K-1s
- Profit-and-loss statements
- Balance sheets
- Business bank statements
- Cash-flow statements or projections
- Information about existing business debts
Primary Benefits of an S Corporation
Potential advantages of an S corp may include:
- Avoiding double taxation. S corps generally don't pay federal income tax at the corporate level. Instead, taxable income and other tax items pass through to shareholders.
- Potential self-employment tax savings. An S corporation’s pass-through business income generally isn’t subject to self-employment tax, so this classification can reduce the employment tax burden. However, shareholders who work for the company must receive “reasonable” compensation for their services, and those wages are subject to Social Security and Medicare payroll taxes.
- Potential Qualified Business Income (QBI) deduction. Eligible S corp shareholders may be able to deduct up to 20% of their qualified business income, along with certain qualified REIT dividends and publicly traded partnership income. The S corporation provides the information needed to calculate this deduction.[6] Income limits and other restrictions may apply.[6]
Potential Drawbacks of an S Corporation
Possible disadvantages of S corps may include:
- Eligibility and ownership restrictions. S corps cannot have more than 100 shareholders, may issue only oneclass of stock, and cannot allow certain types of shareholders, which may limit the company’s ability to raise money through stock issuance.
- More administrative requirements. S corps have ongoing federal filing and reporting obligations, which take time and cost money.
- Payroll requirements. Shareholder-employees generally must be put on payroll and receive reasonable compensation for their services.
- Potential tax liability without corresponding cash distributions. Shareholders report and pay tax on their allocated share of S corp income, even if the company retains the cash rather than distributing it.
- Potential additional taxes. Although S corps generally avoid federal corporate income tax, entity-level taxes may be levied in certain cases (such as the built-in gains tax or excess net passive income tax).[1] State tax treatment also varies, and some states impose income, franchise, or other taxes on S corps.
Comparison of S Corporations to Common Alternatives
| S Corporation | LLC (Default Tax Treatment) | Partnership | C Corporation | |
| Federal tax | Pass-through | Pass-through | Pass-through | Corporation pays federal income tax; shareholders may also owe tax on dividends |
| Liability | Limited liability through underlying corporation or LLC | Members generally have limited personal liability | Varies by partnership type; general partners generally have personal liability | Shareholders generally have limited personal liability |
| Owners | 1–100 shareholders; restrictions on who can be a shareholder | One or more members | Two or more partners | One or more shareholders; generally no restrictions on shareholder number/type |
| Stock classes | Can issue one class of stock | N/A | N/A | Can issue multiple classes of stock |
| Self-employment tax | Pass-through income generally not subject to SE tax; shareholder-employee wages are subject to payroll taxes | Generally subject to SE tax under default taxation, depending on ownership and participation | Partners' business income generally subject to SE tax, with exceptions (such as certain limited partners) | Shareholder income generally not subject to SE tax; employee wages are subject to payroll taxes |
| Investor suitability | Moderate — Ownership and stock restrictions can limit outside investment | Moderate to high —Flexible ownership structure, though suitability depends on tax treatment and operating agreement | Moderate — Can accommodate multiple owners and flexible economic arrangements | High — Generally best suited to businesses seeking substantial outside equity investment |
How to Elect S Corporation Status
Follow these steps to elect S corp federal taxation status:
- Confirm eligibility. Make sure the business will meet the IRS requirements for S corp status.
- Establish the business entity. Form the corporation or LLC under applicable state law and obtain an EIN (employer identification number), if needed.
- Obtain owner consent. All shareholders (or LLC members who will be treated as shareholders) must consent to the election.
- Complete Form 2553 and file it on time. This IRS form should be submitted no later than two months and 15 days after the beginning of the tax year in which the election should take effect. If the deadline is missed, the business may still qualify for late-election relief in some cases.[7]
- Wait for IRS confirmation. The IRS will notify the business to confirm whether the election was accepted.
Is an S Corporation Right for You?
S corporations can be an attractive option for eligible businesses seeking pass-through taxation and potential self-employment tax savings while maintaining the liability protections of their underlying business structure. However, S corp status also comes with eligibility restrictions, tax rules, and ongoing compliance requirements.
Because your choice of business structure and tax treatment can affect everything from your tax liability to your business growth opportunities, consider consulting with legal and tax professionals to determine whether an S corp makes sense for your business.
