Key takeaways
- S corporations offer the tax benefits of pass-through entities like partnerships and sole proprietorships. This means the business itself generally doesn't pay income taxes. Instead, profits and losses pass through to shareholders' personal tax returns, preventing the double taxation typical of C corporations.
- To qualify as an S corporation, a business must meet specific requirements, such as being an eligible domestic corporation, limiting the number of shareholders to 100, and ensuring shareholders are eligible individuals, trusts, estates, or tax-exempt organizations.
- Each year, S corporations must file Form 1120-S to report income, gains, losses, deductions, and credits to the IRS. They also have to provide each shareholder with a Schedule K-1, detailing each shareholder's share of the business's profits and losses.
- S corporations also offer shareholders the liability protection commonly associated with C corporations.
What is an S corporation?
An S corporation (or S-corp for short) is a type of business entity allowed under Subchapter S of the federal tax code. They’re a popular choice for small businesses, because they combine the liability protection of a C corporation with the tax benefits of a partnership or sole proprietorship. S-corps are also relatively easy to set up and manage.
To be eligible for S corporation status, a business must satisfy certain requirements concerning its location, stock, and shareholders. The business also has to file an election with the IRS to be treated as an S corporation.
However, despite their many benefits, an S-corp isn’t the right type of business entity for all business owners. That’s why you might want to consult with a tax professional or attorney before selecting a structure for your business.
In the discussion that follows, we’ll explore the tax implications and requirements of S corporations in more detail, and compare S-corps to some other common types of businesses. In the end, you should have a general understanding of how S-corps and other business entities work, which will help you determine if an S-corp is the best fit for you as a business owner.
Taxes on S corporations
The taxation of S corporations is one of the key considerations for small business owners considering this type of business entity. And when it comes to income taxes, the most important feature is that S corporations are taxed as pass-through entities under the federal tax code.
This means an S corporation’s income, losses, deductions, and credits are passed directly to its owners, who are referred to as shareholders. The shareholders are then required to report their proportionate share of these items on their personal income tax returns. As a result, the business’s net income is taxed at each individual shareholder’s tax rate. (Note that S-corp taxable income that’s not distributed to shareholders can still be passed through to shareholders. In that case, shareholders may have to pay tax on this “phantom income.”)
TurboTax Tip: Self-employed people who operate as an S corporation might be able to reduce the self-employment tax they would have to pay if they operated as a sole proprietorship. As an S-corp, you can classify some of your income as salary and some as a corporate distribution. FICA payroll taxes (which are similar to self-employment taxes) will have to be paid on the salary, but not on the distribution. Plus, the S-corp can deduct the employer’s share of FICA taxes as a business expense.
The main advantage of pass-through taxation is that the business itself generally isn’t subject to federal income tax. This helps avoid the “double taxation” commonly associated with C corporations, where income is taxed at both the corporate level and again at the shareholder level when dividends are distributed.
However, being a pass-through entity doesn’t necessarily mean an S-corp is completely relieved of all tax obligations. They’re still required to pay certain taxes and file various tax forms.
Let’s take a closer look at some of an S corporation’s tax responsibilities.
Federal income tax filing requirements and deadlines for S corporations
An S-corp is required to file Form 1120-S each year. The form is used to report the business’s income, gains, losses, deductions, and credits to the IRS.
S corporations also have to provide each shareholder with a Schedule K-1, which reports their share of the business's profits and losses.
Both Form 1120-S and the Schedule K-1 forms are due by the 15th day of the third month after the end of the S corporation's tax year, which is March 15 for calendar-year S-corps.
If the S corporation is unable to file its tax return by the deadline, it can request an automatic six-month extension by filing Form 7004 by the original due date. For calendar-year S-corps, this pushes the deadline to Sept. 15. The due date for Schedule K-1 forms is also delayed if the deadline for Form 1120-S is extended.
Form 7004 does not extend the time to pay any tax due (see below). As a result, any expected tax due must be paid by the original due date to avoid IRS interest and penalties.
(Note that any due date that falls on a weekend or legal holiday is pushed back to the next business day. This applies to all business tax deadlines applicable to an S-corp.)
Federal taxes paid by S corporations
While an S-corp benefits from pass-through taxation for income tax purposes, it can still be subject to other federal taxes – especially if it was previously a C corporation. Here’s a look at some other federal taxes an S corporation might have to pay.
Employment taxes. S corporations are responsible for paying employment taxes on salaries paid to employees. This includes withholding federal income tax, Social Security and Medicare taxes (FICA), and unemployment taxes (FUTA). These obligations are comparable to the payroll taxes paid by other business entities that have employees.
Built-in gains tax. Businesses that convert from a C corporation to an S corporation might owe the built-in gains tax. This tax is imposed if the S-corp sells assets within five years of the conversion that had increased in value while it was a C corporation. The tax is calculated on the increased value that was "built-in" at the time of the conversion.
Excess net passive income tax. Certain types of income that you don’t have to actively work for – such as gains from selling stock, royalties, rents, dividends, interest, and annuities – are considered passive income. If an S corporation has both passive investment income exceeding 25% of its gross receipts and accumulated earnings and profits from a previous year when it was a C corporation, it may face a corporate-level tax on the excess net passive income.
LIFO recapture tax. S corporations that used to be a C corporation could might have to pay a tax if either:
- the business used the last-in, first out (LIFO) inventory pricing method for its last tax year as a C corporation
- the C corporation transferred LIFO inventory to the S corporation in certain transactions in which gain or loss is not fully recognized
The tax is paid in four equal installments. The C corporation pays the first installment by the due date (not including extensions) of its last tax return as a C-corp or for the tax year of the inventory transfer. The S-corp pays the remaining installments by the due date (not including extensions) of Form 1120-S for the next three tax years.
Excise Taxes. Depending on the nature of the business, an S-corp may have to pay federal excise taxes. These taxes are imposed on specific goods, services, and activities, such as communication services, air transportation, fuel, and tobacco products.
State taxes paid by S corporations
Depending on where your business is located, the taxation of S corporations might work differently on the state level. This makes working with a qualified tax professional even more important.
For example, from an income tax standpoint, most states recognize federal elections to be treated as an S-corp – but a handful of states don’t. If that’s the case, you might have to file a state S-corp election form, pay taxes as another type of business entity (such as a C corporation), or pay some other state-level tax. And a few states don’t tax an S-corp’s income at all.
Most states allow (or require) S-corps to file state income tax returns on behalf of certain nonresident shareholders. These returns are known as “composite returns.”
In addition, many states permit S corporations to pay state income taxes for their shareholders at the corporate level. This option can help shareholders get around the $10,000 cap on the federal deduction for state and local taxes, which only applies to individual taxpayers. Essentially, the S-corp can deduct state and local taxes in excess of the $10,000 limit, and then pass the full deduction through to its shareholders as a state tax credit, deduction, or exclusion.
S-corps might also have to pay state or local sales, property, or excise taxes.
Setting up an S corporation
Your business has to satisfy certain requirements to be eligible for S corporation treatment. If all the boxes are checked, there are also a few steps you have to follow for the business to be recognized as an S-corp by the IRS and the state tax agency where you’re located.
S corporation requirements
To qualify as an S corporation, a business must be an eligible domestic corporation. However, certain financial institutions, insurance companies, and domestic international sales corporations aren’t eligible for S-corp status.
An S corporation can’t have more than 100 shareholders. And only individuals, certain trusts, estates, and certain tax-exempt organizations can be shareholders. Partnerships, corporations, and nonresident aliens can’t be shareholders.
S-corps can only have one class of stock, too.
Electing S corporation status
If your business is qualified for S-corp status, you still need to take certain steps to elect that status.
For example, you first need to incorporate your business. This step is generally handled at the state level by filing articles of incorporation, paying a fee, and satisfying other requirements.
Once your corporation is formed, you also need to apply for an Employer Identification Number (EIN) from the IRS using Form SS-4. The EIN is essentially a Social Security number for your business and is necessary for tax filing and reporting purposes.
To formally elect S corporation status, you must file Form 2553 with the IRS. Each shareholder has to consent to the election by signing the form or a separate consent statement. Form 2553 must be filed within two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year before the tax year it’s to take effect.
As noted earlier, you might also have to file a state election form if you operate in a state that doesn’t recognize your federal S-corp election.
S Corporations vs. other types of businesses
There are several different types of entities that you can choose for your business, including C corporations, S corporations, general partnerships, limited liability companies (LLCs), and sole proprietorships.
When weighing the pros and cons of different types of businesses, owners will look at a wide variety of factors. For instance, among other things, they typically examine each potential business entity’s:
- formation process
- ownership restrictions
- management
- liability protections for the owners
- taxation
Let’s take a quick look at how S-corps and other business entities stack up when it comes to these considerations.
Process for forming the business
S corporations. You generally need to file articles of incorporation, pay state fees, and satisfy other state requirements to incorporate the business. You also have to formally elect S-corp status with the IRS.
C corporations. As with an S-corp, you generally need to file articles of incorporation, pay state fees, and satisfy other state requirements to incorporate the business.
General partnerships. You typically have to draft a partnership agreement and register with the state.
Limited liability companies. You generally need to file articles of organization with the state and pay a fee.
Sole proprietorships. Essentially, you’re considered a sole proprietor once you start conducting business and earning income from business activities. Depending on the business and your location, you may need to register a business name or obtain a business license from your local government.
Ownership restrictions
S corporations. As described earlier, there’s a 100 shareholder limit for S-corps. In addition, only individuals, certain trusts, estates, and certain tax-exempt organizations can be shareholders. Nonresident aliens can’t be shareholders, either.
C corporations. There’s no limit to the number or type of shareholders a C-corp can have. They can have a wide variety of shareholders, including individuals, other corporations, and foreign individuals or entities.
General partnerships. General partnerships need at least two partners, but there’s no limit to the number of partners beyond that requirement. Partners can be individuals, corporations, or other partnerships.
Limited liability companies. LLCs have no limitation on the number of owners (called “members”). They can also be owned by individuals, corporations, other LLCs, and foreign entities.
Sole proprietorships. There’s only one owner in a sole proprietorship.
Management of the business
S corporations. S-corps are run by a board of directors and officers – not the shareholders. However, shareholders can serve on the board or as an officer, which often happens with small S corporations.
C corporations. C-corps are also managed by a board of directors (big-picture decision making) and officers (day-to-day operations).
General partnerships. The partners in a general partnership typically have an equal say in management decisions, unless the partnership agreement says otherwise.
Limited liability companies. An LLC’s management structure is flexible. They can be run by members or by appointed managers.
Sole proprietorships. A sole proprietor has complete control over all business decisions and operations.
Liability of owners
S corporations. Shareholders generally aren’t personally responsible for the business’s debts and liabilities.
C corporations. As with S-corps, shareholders are protected from personal liability for the business’s debts and liabilities.
General partnerships. General partners are typically personally responsible for the business’s debts and liabilities.
Limited liability companies. As the name suggests, LLCs provide limited liability protection to its members, so they’re usually not personally responsible for the business’s debts or the liabilities of the other members.
Sole proprietorships. With full control over management of the business comes a personal responsibility for all business debts and obligations.
Taxation by the IRS (state rules may differ)
S corporations. S-corps are pass-through entities, which means there’s generally no federal income tax at the corporate level. Instead, the shareholders pay tax on their share of the business’s income. Even though an S-corp itself isn’t required to pay federal income taxes, it has to file Form 1120-S to report its income, deductions, credits, and more to the IRS. An S-corp also has to send a Schedule K-1 to each shareholder.
C corporations. A form of “double taxation” applies to C corporations. The business pays a corporate-level federal tax on its own income using Form 1120, while shareholders also pay personal income tax on dividends paid to them by the corporation.
General partnerships. General partnerships are pass-through entities. So, there’s generally no partnership-level federal tax and the owners pay tax on their proportional share of the business’s income. However, a partnership is still required to file Form 1065 to report its income, deductions, tax payments, and more to the IRS. Partnerships also have to send a Schedule K-1 to each partner.
Limited liability companies. The federal taxation of LLCs is unique. They can pick whether to be taxed as a corporation, partnership, or sole proprietorship. For LLCs with at least two members, the IRS treats them as a partnership unless the business formally elects to be treated as a corporation. The IRS considers LLCs with only one member to be a sole proprietorship unless corporate tax treatment is formally elected.
Sole proprietorships. With regard to the federal taxation of sole proprietorships, the business’s profits and losses are passed through directly to the owner. The business’s income and expenses are reported on the owner's personal tax return, so no separate tax form is required for the business itself. All income from the business is typically subject to self-employment taxes.
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