Definition
An S Corporation (S Corp) is a type of corporation in the United States that is designed to avoid the double taxation drawback of regular C Corporations. In an S Corp, income, losses, deductions, and credits pass through to shareholders, who report them on their individual tax returns. This way, business profits are taxed at the shareholder’s personal rates, not at the corporate level.
Key Takeaways
- An S Corporation (S Corp) is a type of corporation that is designed to avoid the double taxation drawback that regular C corps suffer from. This is achieved by having its profits, losses, deductions, and credits pass through to shareholders’ individual tax returns.
- S Corporations are restricted to a maximum of 100 shareholders, all of whom must be U.S. citizens or residents. In addition, S Corps cannot be owned by C Corps, other S Corps, LLCs, partnerships or certain trusts.
- Although S Corps provide owners with the same limited liability protection as C Corps, they also have administrative burdens similar to partnerships or LLCs. These include the requirement to adopt bylaws, issue stock, hold regular meetings, and keep corporate minutes.
Importance
The finance term “S Corporation” (S Corp) represents a crucial business entity type. It’s important because it combines the limited liability protection of a corporation with the tax benefits of a partnership or sole proprietorship.
In an S Corporation, profits or losses are passed directly to the shareholders who report them on their individual tax returns, effectively avoiding the double taxation often encountered in traditional corporations. This characteristic can lead to significant tax savings.
Furthermore, S Corporations can attract investors through the sale of shares of stock, contributing to capital formation and business growth. Understanding the implications of an S Corp structure can be essential for business owners and investors when making financial decisions.
Explanation
An S Corporation, often abbreviated as S Corp, is a type of corporation designed to allow the financial particulars, such as income, losses, deductions and credits, of the corporation to pass through to the shareholders.
Entities choose to become an S Corp with the primary purpose of avoiding double taxation that usually occurs in traditional corporations, which are subject to tax at the corporate level and again at the shareholders level when earnings are distributed as dividends.
S Corporations are commonly used by small business owners to reap the benefits of limited liability- like a corporation- while avoiding the burden of double taxation.
Moreover, the shareholders of an S Corp can offset non-business income with losses from the business, an advantage not available to regular C corporations.
However, to be considered an S Corp, a corporation must meet certain IRS criteria, such as having only one class of stocks and less than 100 shareholders, all of whom must be US citizens or residents.
Examples of S Corporation (S Corp)
Chipotle Mexican Grill Inc.: One of America’s most popular fast food chains, Chipotle, was an S Corporation primarily in its early years. As an S Corp, the company enjoyed the benefit of absence of double taxation since earnings were passed directly to its shareholders.
Chobani: The popular yogurt brand started as an S Corp in its initial years. The incorporation helped the organization to avoid double taxation and let it pass the income, deductions, and credits through to shareholders for federal tax purposes.
Great Clips Inc.: A well-known hair salon franchise in the U.S., Great Clips was structured as an S Corporation. This allowed the company to avoid paying federal income taxes at the corporate level, instead passing the company’s profits through to shareholder tax returns to avoid double taxation.
S Corporation (S Corp) FAQs
What is an S Corporation?
An S Corporation (S Corp) is a type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the shareholders and again to the corporation) by electing to be treated as an S Corporation.
What are the advantages of an S Corp?
The primary advantage of an S Corp is the tax savings for both the business and shareholders. Also, it provides corporate veil protection, which means shareholders have limited liability for the financial risks of the corporation.
How to form an S Corp?
First, the business must be incorporated as a domestic corporation. After incorporating, all shareholders must sign and file Form 2553 to elect your corporation to become an S Corp. The form must be signed and filed no more than two months and 15 days after the beginning of the tax year when the election is to take effect.
Who can file S Corp status?
Domestic corporations, certain banks, life insurance companies, and corporations with an actual small business investment company (SBIC) as shareholders can file S Corp status. However, they must meet all other criteria and the IRS must approve the status.
How does an S Corp differs from a C Corp?
The biggest difference between S Corps and C Corps relates to taxes. C Corporations are taxed at the corporate level, and then any dividends distributed to shareholders are also taxed. An S Corporation allows profits, and some losses, to be passed through directly to owners’ personal income without ever being subject to corporate tax rates.
Related Entrepreneurship Terms
- Pass-through Entity
- Shareholder Restrictions
- Business Income Deduction
- Double Taxation Avoidance
- Corporate Liability Protection
Sources for More Information
- Internal Revenue Service (IRS): The official website of the IRS offers comprehensive information about S corporations, including their tax benefits and how they can be formed.
- U.S. Small Business Administration (SBA): The SBA website provides guides and resources regarding all aspects of running a small business, including choosing a business structure like an S corporation.
- Investopedia: This site is an incredibly valuable resource for all types of financial information, including detailed explanations of S corporations and their advantages and disadvantages.
- Fundera: Fundera’s site offers various resources on small businesses, including articles explaining the process to become an S corporation and its implications.
