What Is an S Corporation? Benefits, Drawbacks, How to Form

An S corporation, or S-corp, is a special designation carved out of the U.S. tax code for small businesses. When you see “Inc.” at the end of a business name, it’s not just for show. Being a corporation signifies that a business is essentially a separate entity from its owners.

But is it the right way to structure your business? As an owner, your biggest incentive in setting up your company as an S corporation is to cut costs, especially on taxes, although choosing that structure could limit your options for growth.

What it means to be an S corporation

If your small business is an S corporation, you’ll enjoy limited liability, which generally means the company, not the people who own it — the shareholders or investors — will be held legally liable for debt and other financial obligations.

But there are two important points to keep in mind. First, you’ll face constraints on who can own your small business, which could hamper your ability to expand (more on this later).

You also have to keep in mind rules about paying your 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.

Who can own an S corporation?

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. According to the agency, a person can be considered a resident alien, even if he or she is 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.

Benefits of an S corporation

Pass-through status: If you structure your business as an S-corp, you’ll pay taxes only on the money you earn from your business, which is recorded as personal income. Your business itself is not taxed.

“So if you’re very early stage and you are just putting money into the company and operating at a loss, that can be great because you get to write off those losses on your personal tax returns,” says Laura Norris, assistant clinical professor and director of the Entrepreneurs’ Law Clinic at the Santa Clara University School of Law. “If you’re making money, it just adds on to your personal return.”

Limited liability: Shareholders of an S corporation aren’t personally liable for actions of the company. This means that the owners’ personal assets — homes, cars, bank accounts, investments — are protected from creditors seeking to collect from the business.

Lower Social Security and Medicare taxes: An advantage S-corps have over unincorporated businesses is that owners of unincorporated businesses are personally responsible for paying Social Security and Medicare taxes (collectively known as self-employment tax) on all net earnings from the business. Owners of corporations who are also employees pay taxes based only on their compensation.

Drawbacks of an S corporation

Restrictions on shareholders: Electing to be an S-corp could be the wrong choice if you’re looking to grow your business quickly. Figuring out how to pay for equipment or other assets can be a challenge, because rules on who can invest in your small business limit your ability to expand your base of shareholders. You can’t invite a venture capitalist or some other entity for support, and you’re constrained by the no-more-than-100-shareholders rule.

This means that, if you really need to raise more money for your small business, you may have to funnel some of your company’s profit back into the firm. In that case, you could get hit with a big tax bill on your personal return without having the proceeds from the business to pay the obligation.

Administrative complexity: If you’re running a corporation, every state has tax and legal hoops to jump through for your business to become and remain compliant; New York, for instance, has requirements for corporations on annual board and shareholder meetings, as well as minutes from those meetings and detailed records of shareholders. Then there are other requirements from the federal government, which have an impact on how your business’s profits are taxed.

For example, you have to file forms 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.

The number of details can be daunting for new business owners.

“If it’s just you or a small group of people who are less experienced, you can flub those and find yourself in trouble,” said Eric Williams, a small-business attorney in Detroit. “That’s a drawback of a corporation.”

How to start an S corporation

• 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 site in your state and any others in which you plan to do business.

• 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.

• 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.

• 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.

• 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.

Want to start a business?

NerdWallet has rounded up some of our best information on starting a business, including structuring and naming your company, creating a solid plan and much more. We’ll help you do your homework and get started on the right foot.