All new enterprises must select a business structure—such as a C corporation, S corporation, or limited liability corporation—and incorporation offers stronger legal protection than remaining unincorporated.
Federal Requirements for an S Corporation
An S corporation (or S corp) is a common choice for companies that want to avoid the double taxation—when a business is taxed as an entity and the business owners are taxed again as individuals on their income—of a C corporation (C corp). Some limited liability companies (LLCs) also may elect to be taxed as an S corp, so long as they meet the following federal requirements from the Internal Revenue Service (IRS):
- Be a domestic corporation.
- Has only allowable shareholders: individuals, certain trusts, and estates. Not permitted are partnerships, corporations, or non-resident alien shareholders.
- Have 100 or fewer shareholders.
- Have only one class of stock.
- Not be an ineligible business, such as insurance companies, some financial organizations, or domestic international sales corporations.
How to Create an S Corporation
There are two general steps qualifying businesses must take to form an S corp, according to the IRS:
- File articles of incorporation. Unless the business is an LLC electing to be taxed as an S corp, businesses must file articles of incorporation with their home state’s secretary of state. Articles of incorporation often include business name, identity and address of the registered agent; elected corporate structure (in this case, an S corp); name and addresses for all members on the board of directors; type and number of authorized shares available; and information about the incorporator of the business.
- File as an S corporation with the IRS. Once the state has approved the articles of incorporation, the incorporator needs to file Form 2553 with the IRS.
What Are the Advantages and Disadvantages of an S Corporation?
Business owners should think of their business’s needs and the advantages and disadvantages of an S corp when weighing if it’s the right structure for them. The following are generally accepted as the clear advantages and disadvantages for the S corporation business structure:
Advantages:
- S corps provide strong legal protection for business owners by separating their assets from the company’s assets. This prevents legal action—like collection efforts by creditors—from involving an owner’s personal bank accounts, property, cars, or other assets.
- S corps eliminate the double taxation inherent to a C corporation, which ultimately saves business owners money. An S corp does not pay corporate taxes; profits and losses pass through to the shareholders’ personal accounts, and taxes and are reported on individual income taxes.
- The IRS considers S corp employees as members—shareholders—allowing them to receive dividend payments from company profits.
- Forming an S corporation can increase credibility with investors, customers, and suppliers.
Disadvantages:
- Some states may still require an S corporation to pay taxes like a C corporation does. It’s important to thoroughly research tax law in the company’s home state.
- An S corporation must elect a board of directors and appoint corporate officers, which may make it more challenging to manage than an LLC.
- An S corporation has more rigid guidelines from the IRS than an LLC does.
- IRS regulations require that S corporation employees receive a “reasonable employee salary.” Generally, this means a salary comparable to those other businesses pay for the same service, which may not be financially feasible for a newer business with a single owner.
Are LLCs and S Corporations the Same?
No. Though an LLC can elect to be taxed as an S corp and both business structures provide personal liability protection for the business owners, there are still notable differences. The biggest is that the federal government considers LLC owners self-employed, meaning they must follow self-employment regulations, including paying additional self-employment taxes.
Is an S Corporation the Best Choice for You?
As a business owner, there are many factors to consider, each of which is unique to your business goals and situation: liability, management and operations, tax consequences, and more.
We invite you to enroll in our non-credit certificate course: A Legal Toolkit for Starting and Scaling Your Business, led by Lynnise E. Pantin, Pritzker Pucker Family Clinical Professor of Transactional Law and founding director of the Columbia Law School Entrepreneurship and Community Development Clinic.