An S corporation is a special type of corporation that draws its designation from Subsection S of the tax code. To start an S corporation, a small business owner starts a C corporation, then files a Form 2553.

S-Corps do have more operating requirements and ownership restrictions than an LLC, but they also have significant advantages. One advantage of the S Corporation is that like the LLC it receives pass through taxation.

Pass through taxation simply means that federal income tax is not assessed at the entity level; profits are distributed in the form of dividends and flow through to the individual tax returns of the shareholders, and the IRS taxes the shareholders at their individual income tax rate and not at the entity or corporation level. Unlike an LLC, Forming an S Corporation can give you the ability to minimize payroll and self employment taxes, resulting in significant savings in certain situations.

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How Is an S Corp Different from a C Corp or an LLC?
Unlike traditional C Corporations, also called C Corps, the S Corporation is not subject to corporate income taxes. Instead, the S Corporation receives different treatment for tax purposes that is generally more favorable to the business owner. The S Corp is a pass-through entity for tax purposes, similar to the LLC. This means that the income generated by an S Corporation will flow through to the personal income tax returns of the shareholders, and the S Corp itself generally does not owe any tax liability.

Structuring your business as an S Corp also gives you certain flexibility for managing the ownership of the company. The stock of S Corporations is freely transferable, while the interest (ownership) of LLCs is not. This means that the shareholders of S Corporations can sell their ownership interest without obtaining the approval of the other shareholders.

Another area of concern for business owners is reducing their liability for self-employment taxes, and an S Corporation can have an advantage over an LLC in this area as well. To visualize how much an S Corporation can save you in taxes, check out our S Corporation Tax Calculator.

The compensation (salary and bonuses) of S Corporation shareholders is subject to self-employment tax, but not the profits automatically allocated to them as a shareholder. Depending on how you pay yourself throughout the year, and depending on how your income appears on your personal tax return, you can effectively minimize your tax burden by reducing the amount of your business profits that are subject to self-employment taxes. Talk to your accountant or professional tax advisor about the best way to structure your business earnings for tax purposes.

Although the S Corporation offers significant tax advantages and ownership flexibility, it is not the right choice for every business. There are a few restrictions as well.

An S Corporation must adhere to the following limitations:

• It may not have more than 100 shareholders.
• It is required to be a domestic business entity.
• The shareholders of the S Corporation must be US Citizens or legal residents of the United States.
• The S Corporation is restricted to only one class of stock.

Depending on your long-term business goals – for example, if you want your company to be publicly traded, or if you want to have international shareholders, a C Corporation might be a better choice of business entity, because C Corporations have no limitations on ownership and can offer multiple classes of stock. But if you are a U.S.-based business and are satisfied to work and grow within these limitations, the S Corporation can save you a lot of money and avoid a lot of hassles as your company expands.

How to Qualify for S Corporation Status
According to the IRS, to qualify for S Corporation status, a business must meet these requirements:

• Be a domestic corporation
• Have only allowable shareholders – which may include individuals, certain trusts, and estates, but not partnerships, corporations or nonresident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

The corporation must also submit Form 2553 to elect S Corporation status for tax purposes.