An S corporation is a federal tax status, not a type of business. An LLC or corporation that meets IRS requirements can elect it, letting profits and losses pass through to the owners' personal tax returns instead of being taxed at the company level.
Business owners usually hear about S corporations from a banker, an accountant, lawyer, or another owner, and the pitch is almost always about taxes. For the right company, this status can lower the yearly tax bill and give owners a cleaner way to take home profits.
"There is no such thing as an 'S' corporation. It's a myth," says Michael E. Fiffik, Esquire, a lawyer at a LegalShield® Provider Law Firm. "The S refers to a corporation that's made an election with the taxing authorities for a type of tax treatment, called pass-through taxation."
In other words, you don't form an S corporation. You form an LLC or a corporation, then ask the IRS to tax it a certain way.
The official S corporation definition comes from the IRS: a company that elects to pass its income, losses, deductions, and credits through to its shareholders for federal tax purposes.
"Pass-through taxation refers to a business structure where the income or losses of the business are 'passed through' directly to the owners' personal income tax returns," Fiffik says. "The business itself does not pay corporate income tax."
Compare that with a C corporation, the default tax setup for corporations. A C corporation pays tax on its profits. Then the owners can pay tax again when those profits come out as dividends. Choosing S status can help a business avoid that second layer of tax.
If you work in your business, the IRS generally expects you to pay yourself a reasonable salary. That salary runs through payroll, with normal payroll taxes, before you take extra profit distributions.
At tax time, the company typically files Form 1120-S. Each owner gets a Schedule K-1 showing their share of the results.
To qualify, a business must be a U.S. company with no more than 100 shareholders and only one class of stock. That means every share carries the same rights to profits.
The rules also limit who can own a piece of the company. Individuals, certain trusts, and estates can hold shares. Partnerships, corporations, and nonresident aliens can't. A few business types, like certain banks and insurance companies, are shut out entirely. These limits never expire, and they can shape who invests in your company later.
You form an LLC or corporation under state law. Then, if the company qualifies, you can apply to the IRS for S status.
The request is submitted on IRS Form 2553. File within the first 2 months and 15 days of the tax year or from your entity’s formation, and the election generally counts for that year. For calendar-year companies, that's around March 15. File later, and it typically starts the following year.
Existing businesses can change course, too. An established company that outgrows its default treatment often considers changing an LLC's tax status to an S corporation, which uses the same form.
The election can offer tax upsides for some businesses.
The eligibility rules never stop applying, so selling shares to a partnership or adding a second class of stock later could end the election. That can complicate plans to bring in investors. A reasonable owner salary also means running payroll, with withholding and filings, even in a company of one. The company’s operating agreement or shareholder agreement (depending on whether it is an LLC or corporation) may prohibit transactions that would automatically forfeit a company’s S-election. Or it may require a unanimous vote.
The election adds paperwork, including a separate business tax return each year. And states don't all follow the federal rules. Some tax these companies differently, which can decrease the benefit. A LegalShield Business Plus Supplement can expand a small business membership with more business consultation when the tradeoffs get complicated.
Each federal tax treatment handles taxation, owner pay, and eligible company types a little differently:
LLCs and corporations are business structures. They're the legal entities you form with the state. The differences between a corporation and an LLC involve ownership and how the company runs. Tax classifications are a different thing. Disregarded entity, partnership, S corporation, and C corporation describe how the IRS taxes the income.
Choosing between C corporation and S corporation treatment is a tax decision, not a choice between two business structures.
“Electing ‘S’ tax status is not limited to corporations,” Fiffik says. “The election is also available to limited liability companies.”
Each starts from a different default. A single-owner LLC starts as a disregarded entity. A multi-owner LLC starts as a partnership. A corporation starts as a C corporation.
That question usually comes down to profit, paperwork, and plans, and it's one a lawyer can help you think through. "Usually S status does not convey practical benefits to business owners until the business has more than $30,000 of net annual revenue," Fiffik says. Below that point, the cost of running payroll and filing a separate return can eat up the savings.
Timing plays a role, too. "The deadline for filing the documents to elect 'S' tax status is 75 days after the business entity is formed, or it can be elected by March 15 of each calendar year," Fiffik says. Ownership plans matter as well. Companies courting outside investors sometimes stay with C status, since many investment funds can't hold S corporation shares.
The numbers side of the decision is a job for a tax professional. "Every business owner should have a relationship with an accountant, attorney, and banker," Fiffik says. A lawyer can walk you through the documents and obligations that follow the choice.
Electing S corporation status affects how you pay yourself, what you file, and who can own part of the company. Before you commit, it helps to have a lawyer review your situation.
With a LegalShield Small Business Plan, you can consult a provider law firm on employment law, contract law, and other important business concerns. Owners who want deeper, ongoing guidance as the company grows can add the Business Plus Supplement for expanded business consultation.
If the election sounds right for you, get the legal side lined up first. Learn more about LegalShield Small Business Plan options and pricing.
Sources:
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