What Is an S Corp and Is It Right for Me?

Business structure vs. business taxation

When thinking about S corp advantages, it's helpful to understand the difference between a business entity and its tax status. Before you can be an S corp, you must form a corporation or an LLC by filing paperwork with the state.

Your new business entity will, by default, be taxed in a certain way. Corporations are taxed as C corporations, which means they file a corporate tax return and pay corporate tax. Shareholders who receive profit distributions are also taxed on those profits. This is sometimes referred to as "double taxation."

LLCs are automatically taxed in the same way as sole proprietorships and partnerships. Owners report company profits as self-employment income on their personal tax returns.

But either a corporation or an LLC can change the way the business is treated for tax purposes by electing S corp taxation.

What is an S corp?

Unlike C corporations, S corporations. don't pay corporate income tax. Instead, profits pass directly to owners' personal tax returns. The owners then pay personal income tax on their share of the profits. In this way, S corporations avoid the double taxation of C corporations.

To be an S corp, your business must:

• Have no more than 100 shareholders
• Not have non-resident alien shareholders
• Not have owners that are corporations or partnerships
• Have only one class of stock

Electing S corp. taxation involves filing Form 2553 with the Internal Revenue Service (IRS). You must file the form within IRS deadlines.

Advantages of an S corp for LLC owners

When an LLC is taxed as a sole proprietorship or partnership, the owners are considered self-employed. Owners will pay Social Security and Medicare taxes (known as self-employment taxes) on their full share of the company's profits.

If your business earns significant profits, you may save on self-employment taxes by choosing S corp taxation instead.

S corp owners who work in the business can be company employees, and they must pay themselves a reasonable salary for the work they do. Like all employees, they'll pay Social Security and Medicare taxes on that salary, but additional company profits won't be subject to these taxes.

Owner-employees can also participate in company benefit programs, including 401K and profit-sharing plans. However, some employee benefits like medical and life insurance can be taxable if an employee owns more than two percent of the company.

The main S corp. disadvantage for an LLC is the required paperwork and fees. You must elect S corp. status with the IRS, you'll have to run payroll and withhold taxes, and you may also be subject to greater IRS scrutiny over whether you're paying yourself a fair and reasonable salary.

For a small business with few profits, the disadvantages of an S corp can outweigh the advantages.

C corp vs. S corp tax advantages

While large companies are typically C corporations, small business owners often prefer S corp taxation because their profits aren't taxed at both the corporate and shareholder levels. But there are S corp tax disadvantages for some businesses.

A company might benefit from C corp taxation if:

• It's a startup hoping to attract outside investment. Institutional investors usually prefer C corporations.
• It plans to keep money in the business to fund future growth. C corp shareholders only pay tax on money distributed to them, whereas S corp owners pay tax on all company profits.
• It doesn't meet the requirements for S corp taxation.

The tax advantages of an S corp depend on several factors, including the size and profitability of your business, whether your business is organized as a corporation or an LLC, and your business and personal goals.

It's best to review S corp advantages and disadvantages with a tax professional who can help you think through the issues and make the choice that's best for you and your company.

S corporations have tax advantages that make them a good choice for many small businesses. An S corp is a tax designation that allows a company's profits to pass through to the owners' personal tax returns. Both corporations and limited liability companies (LLCs) can choose to be taxed as an S corp.

S corporation FAQs

What exactly is an S corp, and how is it different from a regular business?

An S corp is a type of corporation with a special tax treatment. When you elect S corp status, your business profits "pass through" directly to your shareholders instead of taxing the corporation directly. This means you avoid the double taxation that happens with C corps, where the business pays taxes first, and then you pay taxes again on any money you take out. 

Who can choose S corp tax status, and what are the rules?

Your business can choose S corp taxation if it meets the IRS’ requirements. You must be a domestic corporation with more than 100 shareholders, all of whom must be U.S. citizens or people who live in the U.S. permanently (no foreign owners allowed). Your business can only have one type of stock or ownership shares, and you can't give some people special privileges over others. Finally, corporations, partnerships, and most trusts can't be owners.

How much money can I save on taxes with S corp status?

The biggest tax savings come from reducing self-employment taxes. Normally, business owners pay 15.3% in self-employment taxes on all their business profits for Social Security and Medicare. With S corp status, you only pay these taxes on the salary you pay yourself as an employee. Any extra profits you take out as distributions don't get hit with self-employment taxes.

What extra work and costs come with choosing S corp taxation?

Choosing S corp status creates significantly more paperwork and ongoing costs for your business. You'll need to set up payroll to pay yourself a regular salary, which means withholding taxes, filing quarterly reports, and potentially hiring a payroll service. You'll also need to follow corporate formalities like holding annual meetings, keeping detailed records, and filing additional tax forms. The IRS watches S corps closely to make sure salaries are reasonable, so you might face audits.

Should I choose S corp status for my LLC?

S corp taxation can be a smart choice for profitable LLCs, but it depends on how much money your business makes. However, choosing S corp taxation means giving up some of the flexibility that makes LLCs attractive. You'll also have to follow stricter rules about how you pay yourself and run your business.

How do I decide if S corp taxation is right for my business?

Start by looking at three key factors, including your annual profit, growth plans, and ability to handle extra paperwork. Consider your future plans—if you want to bring in investors, expand overseas, or have complex ownership arrangements. Finally, honestly assess whether you can handle running payroll, maintaining corporate records, and dealing with IRS scrutiny. 

Even better, you can connect with a business attorney through LegalZoom’s network to get advice for your situation.