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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