What Is a Corporation?
A corporation is a business entity that you form by filing incorporation documents with your state. Corporations differ from sole proprietorships, partnerships or LLCs in a variety of ways. A corporation has shareholders, directors and officers. The shareholders own stock in the company, the directors set policies and oversee the “big picture,” and the officers run the company day-to-day. In a small business, one person may serve in multiple roles.
As a legal entity, a corporation is distinct from its shareholders, meaning shareholders aren’t personally responsible for debts of the corporation (the shareholder liability is limited to shareholder investment). Corporations are also subject to a number of legal requirements to which other types of businesses are not. These include holding regular meetings and keeping corporate records.
What Is an S-Corp?
While a corporation is a type of business entity, an S-corp is a tax designation available to certain corporations and LLCs. S-corps are named from the subchapter of the Internal Revenue Code—subchapter “S”—under which the tax designation is spelled out. The most defining characteristic of an S-corp is its so-called “pass-through” tax structure.
The IRS describes S-corps as corporations that, “pass corporate income, losses, deductions, and credits through to shareholders for federal tax purposes.” In other words, S-corps are exempt from a federal corporate income tax. Instead, income from dividends is taxed only at the individual level under whatever marginal income tax rate applies. (Marginal tax rates currently range from 10% to 37%.) This also means shareholders who meet certain criteria are able to offset corporate losses with income from other sources on personal income statements.
To contrast, C-corp shareholders are not allowed to write off corporate losses to offset other income on personal income statements. These shareholders still pay personal income tax on dividends taken home (at their own bracket’s marginal rate) but only after the whole of the corporation’s gains have been taxed at the corporate income tax rate (currently 21%). This arrangement is referred to as “double taxation” and has historically been viewed as the price to pay for a corporation’s limited liability advantages.
Along with the tax advantages, S-corps still enjoy the same protection from liability offered by corporation status. Similarly, S-corps maintain an independent life from an owner—meaning the departure of key shareholders isn’t as big an obstacle to longevity as it might be for non-corporate business structures. This flexibility extends to relative ease in transferring ownership of the company, through either an outright or gradual sale. That said, most S-corps have some kind of transfer restriction that makes it harder for shareholders to exit than it would be for a C-corp.
S-corp taxation isn’t just for corporations—LLCs that meet eligibility requirements can also elect to be taxed as an S-corp. By default, LLCs are taxed like sole proprietorships or partnerships, meaning the owners are considered self-employed and pay self-employment tax on all business profits. S-corp shareholders can be company employees (rather than self-employed), reporting both a salary and distributions from company profits. S-corp shareholders only pay self-employment tax on the salary component of income, while distribution income isn’t subject to self-employment taxes.
This all sounds great—so why doesn’t every business elect S-corp status? There are a number of stipulations to operate as an S-corp that may disqualify or disincentivize a business otherwise seeking the S-corp benefits. Perhaps most important are the strict limits around shareholders. S-corporations can’t exceed more than 100 shareholders, effectively ruling out corporations that want to go public.
S-corp ownership is restricted largely to individuals, who must also be citizens or permanent residents of the U.S., and to certain domestic trusts, estates and tax-exempt organizations. This rules out ownership from other corporations or partnerships, which are normally permitted to buy stock in a C-corp.
S-corps may receive extra scrutiny from the IRS, especially when it comes to the allocation of income between distribution and salary. Salaries paid to S-corp shareholders must be reasonable, and not artificially low to avoid taxes.