What Is an S Corporation?
An S Corporation is a domestic corporation that passes income, losses, and deductions through to shareholders — avoiding corporate-level federal tax. Learn how S Corps work, who qualifies, and how to elect S Corp status with the IRS.
Bizee Editorial Staff
Editorial Team
Introduction
An S Corporation is a domestic corporation that elects a special federal tax status under Subchapter S of the Internal Revenue Code. Instead of paying corporate-level federal income tax, it passes income, losses, deductions, and credits through to its shareholders, who report them on their individual tax returns.
What is an S Corporation?
An S Corporation is a domestic corporation that has elected pass-through tax treatment under Subchapter S of the Internal Revenue Code. The corporation itself doesn't pay federal income tax on its operating income. Instead, income, losses, deductions, and credits flow through to shareholders, who report them on their individual returns at their own tax rates.
The S Corp is still a corporation under state law — it provides the same limited liability protection as a C Corporation. Shareholders' personal assets, things like a home or personal bank accounts, are generally shielded from business debts and most lawsuits against the corporation. The S election is purely a federal tax designation, not a separate legal entity type.
- Domestic corporation only — formed under U.S. law
- No more than 100 shareholders
- Shareholders must be U.S. individuals, certain trusts, or estates — not partnerships, other corporations, or nonresident aliens
- Only 1 class of stock allowed
- Certain corporation types are ineligible, including insurance companies and financial institutions using specific accounting methods
Why the S Corp structure matters for taxes
The S Corp structure matters because it eliminates double taxation — the situation C Corporations face where income is taxed once at the corporate level and again when distributed to shareholders as dividends. With an S Corp, income is taxed only once, at the shareholder level, at each shareholder's individual rate.
There's also a potential employment tax advantage. Shareholder-employees can receive part of their compensation as wages — subject to payroll taxes — and part as distributions, which aren't subject to self-employment tax. The IRS requires that shareholder-employees be paid a reasonable salary for services performed, so this isn't a loophole, but it can reduce the overall tax burden compared to a sole proprietorship or partnership where all net income is subject to self-employment tax.
The trade-offs are real, though. The 100-shareholder cap and restrictions on who can own shares make S Corps a poor fit for businesses planning to raise outside investment or bring on institutional investors. The IRS also scrutinizes S Corps more closely than LLCs, particularly around reasonable compensation. A tax professional can help you figure out whether the S Corp structure makes sense for your situation.
How an S Corporation works
An S Corporation works by filing a federal tax election with the IRS after the corporation is formed under state law. The corporation files Form 2553, Election by a Small Business Corporation, and all shareholders as of the election date must consent by signing the form. If the IRS approves the election, the corporation is treated as a pass-through entity for federal income tax purposes going forward.
Each year, the S Corporation files an informational return on Form 1120-S. It doesn't pay federal income tax itself, but the return reports the business's income, deductions, and each shareholder's pro rata share. Every shareholder receives a Schedule K-1 showing their portion of the pass-through items, which they include on their individual tax return — whether or not cash was actually distributed to them that year.
One detail that catches people off guard: shareholders owe tax on their allocated share of S Corp income even if the corporation doesn't distribute cash. If the business retains earnings to reinvest, shareholders can end up with a tax bill on income they haven't received. Planning distributions to cover that liability is part of running an S Corp well.
S Corp vs. C Corp
A C Corporation pays federal income tax at the corporate level. When it distributes profits to shareholders as dividends, shareholders pay tax again on those dividends — that's double taxation. An S Corporation skips the corporate-level tax entirely. Income flows through to shareholders and is taxed once, at their individual rates. Both structures provide the same limited liability protection under state law.
S Corp vs. LLC
An LLC is a distinct legal entity type formed under state law. By default, a single-member LLC is taxed as a sole proprietorship and a multi-member LLC is taxed as a partnership — both are pass-through structures. An LLC can also elect to be taxed as an S Corporation if it meets the eligibility requirements. The S Corp election doesn't change the LLC's legal structure; it changes only how the IRS treats it for federal tax purposes.
Frequently asked questions
The S stands for Subchapter S of the Internal Revenue Code — the section of federal tax law that governs this type of pass-through election. It doesn't refer to the size of the business or any other characteristic. The full legal name is "S Corporation" because the entity has elected treatment under Subchapter S.
It depends on your tax situation. The main reason business owners choose an S Corporation is to avoid double taxation and potentially reduce self-employment taxes. Shareholder-employees can split compensation between a reasonable salary and distributions — only the salary portion is subject to payroll taxes. That split can lower the overall tax burden compared to a sole proprietorship or partnership, where all net income is subject to self-employment tax. A tax professional can help you figure out whether the math works for your income level.
An S Corporation passes its income, losses, deductions, and credits through to shareholders instead of paying federal income tax at the corporate level. The corporation files Form 1120-S each year as an informational return, and each shareholder receives a Schedule K-1 showing their share of the pass-through items. Shareholders report those items on their individual tax returns and pay tax at their own rates — whether or not the corporation distributed cash to them that year.
You file Form 2553, Election by a Small Business Corporation, with the IRS. All shareholders as of the election date must consent by signing the form. The corporation must already be formed as a domestic corporation under state law, and it must meet all S Corp eligibility requirements before the IRS will accept the election. Timing matters — there are deadlines for when the election takes effect for a given tax year, so check the Form 2553 instructions or talk to a tax professional before filing.
An LLC is a legal entity type formed under state law. An S Corporation is a federal tax election that a qualifying corporation — or in some cases an LLC — can make with the IRS. Both structures provide pass-through taxation and limited liability protection, but the S Corp election comes with stricter eligibility rules: no more than 100 shareholders, shareholders limited to U.S. individuals and certain trusts or estates, and only 1 class of stock. An LLC without an S election has more flexibility in ownership structure and fewer ongoing compliance requirements.
Yes, generally. An S Corporation is still a corporation under state law, so shareholders are generally not personally responsible for business debts and obligations beyond their investment. Personal assets — things like a home, car, and personal bank accounts — are typically shielded from claims against the corporation. That protection doesn't extend to a shareholder's own wrongful conduct, though. If you personally commit fraud or negligence, you can still be personally on the hook for that.
