An S corporation is a form of business classified for federal income tax purposes as a corporation that has elected to be taxed as a pass through entity, in a manner similar to a partnership or sole proprietor. Unlike a regular corporation, or C corporation, an S corporation (both names derive from sections of the Internal Revenue Code) generally is not subject to federal income tax. Instead, its income is reported on the tax returns of its shareholders, and they have the responsibility for paying the tax. If there are losses suffered by the corporation, they also pass through and are reported on the shareholders’ income tax returns.
Because only the shareholders, and not the corporation, are taxed, S corporations avoid the problem of double taxation associated with C corporations. This is the biggest draw for creating an S corporation, particularly for closely held corporations.
Shareholders in an S corporation, like shareholders in a C corporation, generally have limited liability arising from corporate matters, even though they pay taxes as if they were partners or sole proprietors. In addition, when the corporation eventually is sold, there can be reduced taxable gains, as compared with the sale of a business operating as a C corporation.
On the downside, the limitation on classes of stock in an S corporation provides less control over the company and the value of its stock. Potential outside investors likely will not be attracted by the pass through tax characteristics of an S corporation, nor by the limit on the number of shareholders. Although corporate taxes are avoided, there is still a requirement for filing an informational tax return every year for a corporation with more than one owner. Finally, if avoiding formalities is an important consideration, it should be noted that, like any other corporation, an S corporation must follow the requirements for having regular meetings and keeping company minutes.
The balancing of the advantages and drawbacks of S corporation status in any given case is sufficiently complex that it is advisable to seek professional advice before making this important choice.