What Is an S Corporation?

An S corporation, or S corp, is a special US federal tax status that a qualifying company can choose in order to change how it is taxed. Despite the name, an S corporation is not a distinct kind of business entity in the way that a corporation or a limited liability company is. It is a tax election, made with the Internal Revenue Service, that allows a company’s income, losses, deductions and credits to pass through to its owners for tax purposes. The “S” refers to Subchapter S of the US Internal Revenue Code, the section that sets out the rules.

The problem S-corp status solves

A standard corporation, known for tax purposes as a C corporation, faces what is often called double taxation. The company pays corporate income tax on its profits, and then shareholders pay tax again on any dividends they receive from those profits. For many small businesses this is inefficient. Electing S-corp status removes the corporate-level income tax on most income: profits are instead reported on the owners’ personal tax returns and taxed once, at their individual rates. This pass-through treatment is the central appeal of the S corporation.

How a company becomes an S corporation

S-corp status is not automatic. A company must first exist as an eligible entity and then file an election with the IRS, using Form 2553, within set time limits. Only certain businesses qualify. The main requirements are that the company must:

• Be a domestic (US) corporation or eligible entity.
• Have no more than 100 shareholders.
• Have only allowable shareholders, generally individuals, certain trusts and estates, but not partnerships, corporations or non-resident aliens.
• Have only one class of stock.

If a company breaks any of these conditions, for example by taking on an ineligible shareholder, its S-corp status can be lost, and it reverts to being taxed as a C corporation.

S corp and LLC: a common confusion

Because both are associated with pass-through taxation, S corporations and LLCs are often confused, but they operate on different levels. An LLC is a legal structure created under state law, whereas an S corporation is a federal tax classification. Crucially, an LLC can elect to be taxed as an S corporation if it meets the eligibility rules, as can a corporation. In other words, “S corp” describes how a business is taxed, not what legal form it takes. A single business can be an LLC for legal purposes and an S corporation for tax purposes at the same time.

Advantages and trade-offs

The principal advantage of S-corp status is avoiding double taxation while keeping the liability protection of a corporate structure. It can also offer savings on self-employment tax, because owners who work in the business can be paid a reasonable salary, with remaining profits distributed in a way that may not attract the same payroll taxes. These potential savings must be weighed against real costs. S corporations face strict eligibility limits, must run payroll and observe corporate formalities, and pay owner-employees a salary that the IRS considers reasonable. The single-class-of-stock rule and the cap on shareholders also make S-corp status unsuitable for companies seeking many or varied investors, or planning an eventual initial public offering.

Why it matters

For many small and medium-sized US businesses, the S-corp election is a valuable tax-planning tool that can reduce the overall tax burden on the owners. But it is only a good fit when the business meets the eligibility rules and the potential savings outweigh the extra administration. Because the choice interacts with legal structure, payroll and each owner’s personal tax position, it is a decision usually made with professional advice rather than in isolation. As a purely US concept, it has no exact equivalent abroad, though many countries offer their own pass-through arrangements for small businesses.