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.

Key characteristics of an S Corp include:

  • 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 one 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.