Nerdy takeaways
- S corps protect your personal assets through limited liability.
- S corps offer tax benefits but can be administratively complex.
- To operate as an S corp you must meet specific requirements, such as having no more than 100 shareholders
What is an S corporation?
An S corporation (S corp) is a way for an eligible business to be taxed so profits and losses “pass through” to the owners’ personal tax returns instead of being taxed at the business level. The “S” designation affects how the business is taxed — not whether it’s a corporation.
An S corp is usually a corporation or an LLC that chooses this tax treatment, and it typically provides limited liability protection, meaning owners’ personal assets are generally separate from the business’s debts and obligations.
For some businesses, an S corp can lower overall taxes, but it comes with strict rules, including limits on the number of shareholders, that can make raising money and scaling more difficult.
How an S corporation works
If your small business is an S corporation, you’ll enjoy limited liability, which means the company, not the people who own it — shareholders or investors — are held legally liable for debt and financial obligations.
But there are two important points to keep in mind.
- You’ll face constraints on who can own your small business, which could hamper your ability to expand (more on this later).
- There are rules about paying employees. As an employer, you’re required to pay Medicare and Social Security taxes on wages you pay. That includes wages you pay to yourself, which has tempted some small-business owners to cut their own pay or not pay themselves at all. But the IRS cracks down hard on that practice. The agency, which expects you to offer “reasonable compensation” to each employee(including yourself), has issued S corporation compensation and medical insurance guidelines to help owners navigate the processes.
The IRS has fairly strict rules on who can hold ownership stakes in an S corporation. For your business to qualify, you’ll have to meet these requirements:
- You can’t have more than 100 shareholders.
- You can issue only one class of stock.
- Your investors can be individuals, as well as “certain trusts and estates,” according to the IRS. You and your spouse can be considered one shareholder. The same goes for members of a family and their estates.
- You can’t have entities, such as partnerships or corporations, as investors
- You also can’t have a “nonresident alien” as a shareholder. According to the IRS, a person can be considered a resident alien, even if they are not a permanent resident or U.S. citizen, as long as the individual has been in the United States for at least 31 days in the current year and 183 days over the last three years. Full details can be found by checking out the “substantial presence” test used by the IRS.
To verify whether your business qualifies as an S corporation, check the requirements listed in the IRS' instructions for Form 2553, which you'll have to file when you incorporate. A key one is that your company must operate domestically.
Pros of an S corporation
| Pass-through status |
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| Limited liability |
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| Lower self-employment taxes, including Social Security and Medicare |
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Cons of an S corporation
| Restrictions on shareholders |
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| Administrative complexity |
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| Federal government requirements |
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How to start an S corporation
1. Choose a name for your business
To make sure someone else doesn’t have your business name, you should do a thorough search of online directories, county clerks’ offices and the secretary of state’s website in your state and in any other states where you plan to do business.
2. Get an employer identification number
You should get an EIN, or a nine-digit number assigned to businesses for tax purposes. The IRS requires any business operating as a corporation to have one. You can apply for an EIN online at no cost. The process takes just a few minutes.
3. Choose a registered agent
The registered agent is the person you designate to receive all official correspondence for the corporation. It’s crucial that you identify who this person will be before filing articles of incorporation, because states generally require you to list a registered agent’s name and address on the form.
4. Register your small business as a corporation in your state
You can find the links to the specific state agencies on the U.S. Small Business Administration website. Each state has its own forms, procedures and fees. Keep in mind that the agency in charge of business entities could have a different name depending on where you incorporate. In most states, the relevant agency is the secretary of state’s office.
5. Elect S corporation status
Once you’ve registered as a corporation in your state, you must elect to become an S corp with the IRS (it’s not automatic). The next step is to file Form 2553. You can get more information on small-business regulations and tax rules in the IRS’ Small Business and Self-Employed Tax Center. You have to file Form 2553 with the IRS within two months and 15 days of the beginning of the tax year to designate your business an S corporation for that year. Or you can make the change one year and have it take effect the following year, according to the IRS.
