Business Entity: What Is An S Corporation?

Once established, it's common for LLC members, freelancers, and small business owners to evaluate tax structure options that may be more favorable to their current revenue and future trajectory. Many will consider an S corporation election for the tax savings and liability protection typically associated with this status.

Use this guide to understand what an S corporation is and how it can help your business grow. It covers how S corp taxation works, potential downsides, and how to pick the best entity for your operations.

What Is an S Corp?

An S corp is not a distinct legal entity, but rather a special federal tax classification elected by filing Form 2553 with the IRS. It allows eligible businesses to enjoy pass-through taxation, avoiding corporate-level income taxes. S corp owners can also reduce their self-employment tax burden by paying themselves a "reasonable salary," which we'll cover in more detail later in this article.

What Are the Benefits of an S Corp?

Electing to operate as an S corp provides several benefits, including:

• Pass-through status, which means you’ll pass your business income, losses, deductions, and credits to shareholders without having to pay corporate tax. Taxes are paid just once based on the individual shareholder's tax bracket. S corps avoid "double taxation" that C corporations are subject to, once at the corporate level, and again on shareholder distributions.

• Limited liability protection means owners and shareholders are generally not personally liable for business debts and lawsuits. In this scenario, their personal assets remain separate from the S corp's assets. Limited liability protection can be lost if the business doesn't actively maintain this status.

• Taxation, where the S corp's profits and losses pass through to stakeholders. That means you’ll pay taxes once, rather than being charged for the profits the corporation earns.

• Saving on the 15.3% self-employment tax that funds Medicare and Social Security. S corp owners who work in the business can pay themselves a "reasonable salary," subject to SE tax, and distributions that aren't. For example, an owner earning $100,000 in net profit pays the full SE tax as a sole proprietor, but only pays that tax on a $60,000 reasonable salary, with the remaining $40,000 in distributions exempt from that tax.

Can You Pay Yourself a Salary in an S Corp?

S corp owners reduce their self-employment tax burden by paying themselves a "reasonable salary." Reasonable salaries can vary, but they are equivalent to what employees or other owners in your industry would earn for similar work. Payroll taxes are assessed only on the salary portion of an S corp owner's compensation, and it's important not to go too low. Artificially low salaries reduce tax revenue and can trigger audits. The IRS can reclassify distributions as wages if the salary is deemed unreasonably low, resulting in back taxes and penalties.

To determine a reasonable salary for yourself and your shareholders, think about:

• Compensation agreements

• Dividend history

• Duties and responsibilities

• Payments to non-shareholder employees

• Time and effort devoted to the business

• Training and experience

• What comparable businesses pay for similar services

You can also use the Bureau of Labor Statistics wage data or industry compensation surveys to establish your defensible salary.

What Are the Downsides to an S Corp?

There are potential downsides to operating as an S corp that you should consider before electing this status.

• S corps are required to file both federal and state taxes, including Articles of Incorporation and corporate minutes. You’ll also hold regular shareholder meetings and pay required government fees if you elect this status.

• There are also shareholder restrictions to consider. Shareholders pay taxes on the S corp's income, even if they didn’t receive any revenue.

• The IRS requires each business owner and officer of an S corp to be paid a reasonable salary, even if the company has not yet made a profit.

• S corp owners are subject to administrative burdens and costs that other business entities avoid. You must run payroll, withhold employment taxes, and file quarterly payroll returns using IRS Form 941, Employer's Quarterly Federal Tax Return.

• Some states, like California and New York, impose additional S corp taxes or require a separate state election filing.

How S Corp Taxation Works

S corps can avoid double taxation because they're pass-through tax entities, meaning that the corporation isn't taxed on its profits. Profits are passed on to shareholders via a Schedule K-1 and are taxed as personal income, which is reported on Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship)

Shareholders can receive dividends, which are the remaining profits after expenses are paid. Shareholders do not have to pay self-employment tax on these earnings.

Since S corp shareholders are employees, any salaries are subject to the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA), not distributions. Distributions are exempt from FICA and FUTA taxes.

How to Form Your S Corp (Formation Steps)

Successfully form your S corp by following these steps.

1. Some Secretaries of State will work with S corp owners. If this is a feature of your state, choose a legal name and reserve it through the state. This ensures compliance with state-level naming conventions and prevents other businesses from claiming it during the reservation period.

2. Draft and file Articles of Incorporation with your Secretary of State. This is the formal document that legally establishes your business. It registers your business, its purpose, and authorized shares.

3. Issue stock certificates to initial shareholders. This officially documents ownership and equity distributions. S corporations can only issue a single class of stock.

4. Apply for all certificates and licenses relevant to your corporation. Depending on your industry and location, you may need licenses to operate legally. Failure to secure all required certificates and licenses can result in fines or forced closures.

5. File IRS Form SS-4, Application for Employer Identification Number (EIN), to obtain an EIN. You'll need an EIN to hire employees and to open a business bank account.

6. Apply for any other ID numbers required by your local and state governments. Several states and municipalities mandate distinct tax registrations, like a state sales tax ID or an unemployment tax account.

7. Complete and submit Form 2553 within 75 days of forming your S corp. This document is what actually grants your business S corporation tax status. Missing this window means the election does not take effect until the following tax year.

1-800Accountant handles entity formation, including preparing and filing Form 2553, as part of its service offering, ensuring your S corp is set up correctly from the start.

How to Pick the Best Business Entity For You

Many businesses start out as sole proprietorships, a default status, for its simplicity. You won't have the obligations associated with other business entities, nor the protection. Once established, it's common for sole proprietors to form as an LLC, which legally separates business and personal assets, for the limited liability protection and increased credibility it provides. However, single-member LLCs aren't taxed any differently than sole proprietorships. Some small businesses with annual revenue of $50,000 to $60,000 will elect S corp status to reduce their self-employment tax burden. Others will form as C corporations when seeking venture capital and to issue different classes of stock.

When selecting the best entity for your business, look at where your revenue is today and where you want your business to go in the future.

State-Level S Corp Considerations

Electing S corp status is a federal designation, with approximately half of U. S. states automatically recognizing it. The other half, including California, New York, and New Jersey, requires a separate state election filing or imposes additional taxes on S corps. For example, California S corps pay a 1.5% state franchise tax on net income, or an $800 minimum, in addition to the federal pass-through treatment.

It's important to understand your obligations before proceeding with an S corp election. Consult with a tax professional before filing to confirm any state formation requirements and ongoing tax obligations.

Choosing the Right Tax Structure for Your Business

Determining the best entity structure for your business can be intimidating, but once you’ve weighed the eligibility requirements, potential tax benefits, and ongoing compliance obligations, the right choice becomes clearer. For small business owners ready to make the switch from their current entity to an S corporation, exploring streamlined entity formation solutions with a dedicated accountant is the most reliable way to ensure you're formed correctly from day one.

Frequently Asked Questions About S Corporations

How is an S corp different from an LLC?

While S corps and LLCs have similarities, there are distinct differences that you should understand. An LLC is a formal legal business structure formed at the state level that protects your personal assets from business liabilities. An S corp is not a legal entity itself. Rather, it is an IRS tax designation that you apply to an eligible LLC or C corp. The primary difference lies in taxation: LLC profits are subject to self-employment tax, whereas S corps allow you to split earnings into a salary and distributions to reduce that tax.

Do I need to file Form 2553 to elect S corp status?

Yes, you must formally elect S corp status with the IRS by submitting Form 2553. This form must generally be filed no later than 2 months and 15 days after the beginning of the tax year you want the election to take effect. Missing that window means the election does not take effect until the following tax year. It requires signatures and consent from all shareholders to be deemed valid by the IRS.

What is a reasonable salary for an S corp owner?

The IRS mandates that any owner performing services for the S corp must pay themselves a "reasonable salary," which is what a similar enterprise would pay someone to perform the same duties. This amount must be a legitimate W-2 salary and paid before any shareholder distributions are taken. Although some accountants use a 60/40 rule of thumb, this is not a legal IRS standard. To qualify, your salary must be based on objective factors like your duties, experience, and comparable market rates.

Can a single-member LLC elect S corp status?

Yes, a single-member LLC is fully eligible to elect S corp tax classification. The single-member LLC owner simply needs to meet all standard S corp qualifications, such as being a U. S. citizen or resident and not being an ineligible corporate entity. The single-member LLC continues to exist legally, but the IRS will evaluate its taxes as a corporate entity rather than as a sole proprietorship. By default, single-member LLCs and sole proprietorships are taxed the same.

What tax forms does an S corp file each year?

An S corp does not pay federal income tax itself; instead, it files an informational return using IRS Form 1120-S. Along with this form, the business must issue a Schedule K-1 to each shareholder, detailing their share of the corporate income or losses. These individual shareholders then report their K-1 information on their personal tax returns.

Does S corp status protect my personal assets?

The S corp tax status itself does not provide legal liability protection. However, because an S corp election is usually made on top of an existing LLC or corporation, your personal assets are shielded from business debts and lawsuits by the underlying entity. To maintain this protection, you must properly maintain corporate formalities, such as keeping business and personal finances strictly separate. Failing to do so might result in a loss of liability protection, making your previously protected personal assets fair game in the event of a lawsuit.

Can I change my mind and revoke S corp status?

Yes, you can revoke your S corp status, but there are usually consequences associated with this action. Doing so generally locks you out of re-electing S corp status for five years without special IRS permission. To revoke the election, the shareholders holding more than 50% of the stock must sign and submit a formal revocation statement to the IRS service center where you file your returns. The statement must indicate the effective date of the revocation and be accompanied by the required corporate signatures.

What happens if my business no longer meets S corp eligibility requirements?

If your S corp inadvertently violates eligibility requirements, like taking on too many shareholders or issuing an ineligible class of stock, your S corp status will terminate immediately. Depending on the cause and whether it was accidental, you may have to request relief from the IRS to restore this tax status. If the termination is permanent, the business will revert to being taxed as a standard C corporation or a disregarded entity.

How does S corp status affect owner draws and distributions?

In an S corp, your compensation is split into a salary and shareholder distributions. W-2 wages are subject to payroll taxes, while distributions are not subject to the 15.3% self-employment tax. You cannot take owner draws in lieu of a salary; you must take a reasonable salary before withdrawing any profit as a tax-efficient distribution.

Will forming an S corp affect my ability to get a business loan?

No, forming an S corp generally will not negatively affect your ability to secure a business loan. Some lenders appreciate that an S corp demonstrates organized financial practices and formal tax reporting. When evaluating a loan, traditional lenders and modern business lenders alike primarily look at the business's cash flow, tax returns, and the owners' personal credit profiles rather than the tax classification itself.