A specific tax designation for corporations (and sometimes LLCs) that meet strict IRS eligibility requirements. The S stands for Subchapter S of the Internal Revenue Code. Unlike a C-Corp, an S-Corp is not a distinct type of legal entity under state law; rather, it is a regular corporation that has elected a special tax status by filing Form 2553.
Pass-Through Taxation
The primary reason for electing S-Corp status is to avoid double taxation. An S-Corp is a pass-through entity, meaning the business itself generally pays no federal income tax. Instead, the company’s profits, losses, and certain credits pass through to the shareholders’ personal tax returns and are taxed at their individual income tax rates.
Eligibility and Restrictions
The IRS limits S-Corp status to closely held businesses that meet these criteria:
- Shareholder Limit: It may have no more than 100 shareholders.
- Shareholder Type: All shareholders must be U.S. citizens or resident aliens. Partnerships, corporations, and non-resident aliens are generally prohibited from owning shares.
- Stock Structure: The corporation can only have one class of stock, meaning all shares must have the same rights to distributions and liquidation.
The Reasonable Salary Requirement
Owners who provide services to the S-Corp must pay themselves a reasonable salary (market-rate compensation) subject to payroll taxes (Social Security and Medicare). Any remaining profits can be taken as distributions, which are not subject to self-employment taxes. This can result in significant tax savings compared to a sole proprietorship or a standard LLC.
Advantages & Use Cases
- Tax Savings: Ideal for profitable, owner-operated small businesses looking to reduce self-employment tax.
- Loss Deductions: Business losses can often be used to offset other personal income on the shareholders’ tax returns.
- Credibility: Offers the same limited liability protection and professional “Corp” title as a C-Corp without the double tax.
