S Corporations: What Are They?

An S corporation is a type of for-profit corporation that has a special tax classification with the IRS. In all other ways, incorporating an S corporation is no different from incorporating a C corporation—both result in the formation of a new legal entity, separate and distinct from the individual owners themselves and able to sue, be sued, and enter into contracts and agreements.

Other than tax treatment, an S corporation is operated in the same way as a C corporation: an S corporation must follow the same corporate formalities necessary to protect the corporate veil. As with all corporations, the directors and officers manage the operations of the S corporation, and corporate profits must be distributed per the stock ownership ratio. (For example, a shareholder with 29% of the shares must receive 29% of the profit, no more and no less.)

After incorporating with the state, a corporation has up to 75 days to file IRS form 2553, the form by which it elect S corporation status. Some states, like California, also have S corporation applications that must be filed with the Secretary of State.

What are the advantages and disadvantages of an S corporation?

An S corporation offers a lower tax burden than its C corporation counterpart, but the trade-off comes in the form of a more rigid corporate structure.

Advantages—Pass-Through Entity

An S corporation is known as a "pass-through entity," meaning that profits are "passed through" to the individuals before being taxed.

In order to understand this concept, it helps to compare the tax structure with that of a C corporation. With a C corporation, profits are taxed once at the corporate level, and then again at the individual level when distributed to the owners. This results in a large amount of corporate profit being taxed twice.

However, in the S corporation tax structure, since gains and losses are reported only on the owning individuals' tax returns, much less money is lost in the form of federal taxes.

Disadvantages—Rigid Structure

While S corporations enjoy tax benefits, there are other restrictions and limitations that typically make S corporations a good option for smaller corporations:

  • There may not be more than 100 shareholders;
  • Shareholders must be individuals who have US citizenship or are resident aliens; and
  • Only one class of stock can be issued.

What are some other benefits of incorporating?

Forming either type of corporation enables you to take advantage of certain benefits and opportunities:

  • Shareholders enjoy limited liability from debts, judgments, or other obligations of the corporation;
  • Unless corporate fraud is a factor, shareholders cannot typically lose any more than the amount of stock they hold;
  • Corporations can raise capital by selling stock; and
  • Corporations may deduct the costs of benefits they provide to their officers and employees, such as health insurance and monthly parking passes.

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