Corporations are a type of American business structure extremely useful for running a business with multiple shareholders, where the transfer of ownership is simple and protects the personal liability of the owners.
What few people know is that there are several types of corporations, and when we refer to the term "Corporation", we are commonly referring to C corporations. However, S-Corps are a structure different, with different obligations, different ways of paying taxes and handling.
In this article, we will go into depth about the “S-Corp” business structure so that you know everything essential about it. Let's get started!
What is an S-Corp?
An S corporation is a tax designation available for certain corporations and LLCs. With S Corp recognition, a corporation is treated by the IRS as a Pass-trough entity, which means that they do not pay corporate taxes, but rather their shareholders are responsible for paying any taxes owed.
S-Corp is only a tax status, and they do not modify the operation of corporations: they will continue to have shareholders, directors and officers, they must hold periodic board meetings, the liability is limited to the investment of the shareholders just like a C-Corp. The same applies to LLCs.
To give context, the term S Corporation comes from “Small Business Corporation”, which is why they are usually associated with smaller businesses, but that want to achieve better tax conditions to grow faster.
What are the requirements to obtain the S-Corp designation?
According to the IRS, to obtain S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only eligible shareholders (They cannot be companies, corporations or non-resident foreign shareholders, for example)
- Not have more than 100 shareholders
- Have only one class of shares
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).
Advantages and disadvantages of S-Corp
Here we leave a table that compares the advantages and disadvantages of S-Corp. We will go into detail below so that you understand how it works.
| Advantages | Disadvantages |
|---|---|
| It does not have the double taxation that C-corps have | Maximum limit of 100 shareholders |
| Corporate losses can be transferred to the owners | Strict requirements for constituent shareholders |
| Limited liability for directors, officers and shareholders | More difficult to obtain capital financing than C-corps |
| Independent life of shareholders | Greater scrutiny by the IRS |
| Taxes are filed annually instead of quarterly. | Only one class of stock is allowed |
| Self-employment tax is lower for LLC owners |
The advantages of an S-Corp
- They do not have double taxation: One of the main advantages that S-Corps have is that they are pass-through entities. This means that, unlike the traditional status of corporations (C-Corp), they do not pay taxes as a corporation. This can save the company significant amounts of money in taxes each year.
- Corporate losses can be passed through to owners: Taxing as pass-through entities means that the company's profits, losses, deductions, and credits are passed along to shareholders, who report them on their individual taxes.
- Limited liability: In addition to the tax advantages, S-corps continue to enjoy the same liability protection offered by corporation status. Its shareholders are protected from personal liability for the debts or obligations of the corporation.
- Independent life of shareholders: Shareholders can come and go, and the corporation will live on. Contrary to LLC, the transfer of ownership is very simple.
- Taxes are filed annually instead of quarterly: An S corporation must file its annual tax return by the 15th day of the third month following the end of the tax year. A C corporation that owes $500 or more in income taxes must make four quarterly estimated tax payments to the IRS.
- Lower self-employment taxes: LLCs can be considered C-Corps (see article on LLC taxes). As the owner of an LLC and a US resident, you will have to pay taxes on all of your company's net profits, while an "S" corporation will only pay taxes on the salary you earn from your company.
The disadvantages of an S-Corp
- 100 Shareholder Limit: To be an S-Corp, the IRS requires that there be no more than 100 shareholders. This means that from a certain level, the company can no longer take advantage of this status, and makes it impossible for companies that want to go public. This also makes itmore difficult to obtain equity financing than with C-corps.
- Strict requirements for its shareholders: Ownership of an S-corp is limited to individuals, citizens or permanent residents of the United States, certain domestic trusts, estates and non-profit organizations. This prevents other corporations or associations from acquiring shares in a C-corp.
- Increased scrutiny from the IRS: S-corps may face an additional level of scrutiny from the IRS, especially with regards to stock and salary distribution of income. Salaries paid to S-corp shareholders are unreasonable and not set artificially low for the purpose of tax avoidance.
- Only one class of stock is permitted: The SEC indicates (Code Sec. 1361(b)(1)(D) and (c)(5); Reg. §1.1361-1(l)) that an S Corporation permits only the issuance of a single class of shares. Although these shares may have different voting rights, it is a fundamental requirement that they grant identical rights regarding the distribution of profits and income generated (Code Section 1361(b)(1)(D) and (c)(5); Regulation §1.1361-1(l)).
How are S-Corps taxed?
As we discussed previously, S-Corps have different tax treatment than regular corporations, as they are exempt from corporate taxes. However, they still must report their profits to the IRS and file tax returns (which is different from having to pay them).
S-Corps must file Form 1120-S, which is a tax return and reports the income, losses, dividends, and other distributions that the corporation has transferred to its shareholders. This form is accompanied by a Schedule K-1, detailing the percentage of shares of the company held by each individual shareholder.
Form 1120-S must be filed once a year. It expires on the 15th day of the third month after the close of its fiscal year (generally March 15 for companies that follow a calendar year).
S-Corps can request a six-month extension to file their tax returns. To do so, they must file Form 7004, before the regular due date of their return.
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How to open an S-Corp?
To obtain the S-Corp tax designation, there are a series of steps to follow that we will describe in detail below.
1. Register your LLC or corporation
The first step to obtaining S-Corp status is to have a formal business structure registered. Multi-person LLCs, Single-Person LLCs, and corporations can apply for the S-Corp designation. If you do not yet have your business registered, we recommend that you follow the following guides:
Whether you opt for a corporation or an LLC, you will have to choose a state to form your business, submit certain documentation to the secretary of state, obtain a registered agent and, in the case of corporations, comply with other regulations such as appointing directors, partners, drafting bylaws, etc...
If you prefer to delegate this process to a professional service, do not hesitate to consult our LLC opening services.
2. Get an EIN
An EIN is a unique nine-digit number that the IRS uses to identify companies for tax purposes. It is a type of Federal Tax ID, for businesses. The secretary of state issues EINs and uses them on state tax forms. The EIN is basically the SSN of companies.
You can request it for free at the IRS website.
3. Verify that your corporation or LLC meets the requirements
Your corporation or LLC must meet each of the requirements to apply for S Status that we have already described in this article.
4. Submit the documentation to apply for S-Corp status
Once you have completed the steps above, you can file IRS Form 2553, Election by a Small Business Corporation, which is the S-Corp election form.
The form can besubmitted online or by mail.
It is also important to be attentive to the moment in which this form is submitted: it must be done within 75 days following the incorporation of your LLC or C corporation, or no more than 75 days after the beginning of the fiscal year in which you want the S-Corp status to be applied. If your election occurs after this period, it will be valid for the following year.
5. Maintain compliance with requirements
You do not need to renew your election to be taxed as an S-corp each year with the IRS, but you do need to make sure your LLC or Corporation continues to meet the requirements. If not, you will have to revert to C-corp status or the traditional LLC tax structure.
Written by
Ignacio Navarro
Ignacio Navarro is a Certified Public Accountant, graduated in 2020 from the National University of Tucumán. Founder of Start Companies since 2023, he advises clients worldwide on forming LLCs in the United States and on proper tax filing. His expertise combines legal, tax, and practical knowledge, offering a comprehensive service that spans from company formation to bank account setup and sales platform integration.
