This article is not intended to be financial advice.

It’s never too late to start your own business. But if and when you do, you want to make sure that you do it right. That includes selecting a tax classification that fits your organizational structure and sets you up to make as much profit as possible. An S corporation, or S Corp, is one of these types of classifications, and choosing to go this route could mean more money in your pocket, plus a number of other key benefits geared toward protecting your profits as a business owner.

Whether you’re starting a small business or your own corporate empire, here’s what to know about S corps—including how they compare to an LLC or sole proprietorship

What Is an S Corporation?

An S corporation (also known as an S subchapter) is a structural designation under the IRS. It provides businesses with many of the benefits of corporate status, but without the double taxation that businesses incur as a C corp, the standard type of corporate legal entity.

With an S corp, all employees—including a sole owner, if they’re working alone—must be paid a salary. It is these salaries, rather than capital gains, that are then subject to taxes, with profit and losses split among owners and then listed on personal tax returns. This is different from how C corps are taxed, since they require the payment of corporate taxes as well.

In order to file as an S corp, a business must meet a number of requirements set out under the Internal Revenue Code:

  • It must first be registered as a C corp or an LLC.
  • It must be owned by a U.S. citizen or citizens, or resident aliens.
  • It must have fewer than 100 shareholders, all of whom must be individuals and not corporations. (Certain types of trusts and non-profits may also meet this requirement.)
  • It must have only one class of stock, meaning that all stock shares are equal, with the only difference being how much stock an individual shareholder has.

Like all incorporated businesses, an S corp also must adhere to certain formalities, such as conducting shareholder meetings, maintaining a board of directors, and writing and adhering to corporate bylaws.

Most small business owners have no trouble meeting the requirements of S corporations. If you have dreams of scaling your business into something larger, however, you’ll need to limit your shareholders and ensure that they are all individual investors and not companies. Failure to do either will result in losing your S corp benefits and status, including freedom from double taxation.  

Can an LLC Be an S Corp?

Yes. An LLC (limited liability company) is a legal designation, while an S corp is a tax designation. Because they refer to different aspects of a business entity, it is possible to be both an LLC and an S corp, though S corp taxes are not the standard tax structure of an LLC, and you’ll have to apply separately if you want S corporation status.

Can a Sole Proprietorship Be an S Corp?

No. The tax and legal differences between a sole proprietorship and an S corporation make it so that one business cannot qualify as both. By definition, a sole proprietorship is not a corporation—instead, it’s recognized as one and the same as its owner, who maintains all profit but who is also subject to all liabilities. 

An S corp, on the other hand, maintains corporate status and is a separate legal entity from its owner(s), who in turn enjoy limited liability from debts and other financial obligations. That being said, both S corp taxes and sole proprietor taxes are exempt from double taxation.

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Why Would You Choose an S Corporation?

So, why be an S corp?

There are quite a few benefits of an S corp that are worth considering when you’re deciding whether or not it’s the right choice for your new business. Notably, S corporation benefits afford you a lot of the same advantages that you would get as a C corporation but without double taxation. If you’re interested in limited ownership for your business and don’t foresee adding any corporate owners to your group of shareholders, then an S corp—and all of the S corp benefits that come with it—could be your best bet.

As for what the benefits of an S corporation really are, here’s a quick look at how they break down.

Benefits of an S Corp

Before you decide to go down the road of how to file as an S corp, make sure that it provides the right set of benefits for your business. These are some of the major benefits of an S corporation that come along with this status:

  • Ownership: S corps may not have more than 100 shareholders, all of whom must be individuals and not corporate entities. This limits the number of owners—and by default, the number of people with a say in how the business operates.
  • Taxes: With S corporation taxes, an owner or owners are only subject to taxes on personal income from the business, as opposed to under a C corp which also incurs a corporate tax. They are also able to write off business losses on their yearly returns.
  • Liability protection: An S corp creates a separation between the owner or owners of the business and the business itself. This provides liability protection, ensuring that business assets, and not personal assets, are on the line in the event of lawsuits or debt.

Are There Any Disadvantages?

With all of the S corporation benefits listed above, you might be wondering why any business owner wouldn’t opt to go this route. But there are a few reasons that owners might choose to keep their business a C corp instead:

  • Ease: S corps are more difficult to form than C corps.
  • Future ownership: S corps cannot be owned by other types of companies, which severely limits the available options if you’re hoping to get acquired later on.
  • Size constraints: The limit on shareholders also places a limit on how large you can scale your business. If you have your sights set on growing a large business, it might not be worth going for S corp status only to have to revert back into a C corp as you expand.
  • Tax considerations: S corp taxes are subject to personal tax only and exempt from corporate tax. But that means they don’t get any corporate tax benefits like deducting the cost of employee health benefits and 100% of charitable contributions.

All of this means that when you’re deciding whether the pros of an S corporation outweigh the cons, you’ll need to keep your long-term goals for your business top of mind. If you have big dreams that go beyond a small and/or freelance operation, you may want to save yourself the trouble of filing as an S corp and go with a C corp or sole proprietor designation instead.

How to Become an S Corp

If you’ve decided that an S corp is the way to go, then your next step is working out how to file as an S corp.

An S corp is an IRS designation, so it’s done at the federal level rather than the state level. You’ll incorporate first with the state, and then apply for S corporation status with the IRS. Here’s how:

Step 1: Incorporate with Your State

In most states, you will be able to incorporate your new business by filing Articles of Incorporation with your Secretary of State. If this isn’t the case in your state, it’s likely that you will have to file with a Business Bureau or Business Agency instead.

At the same time that you do this, check to see if your business will also be required to obtain any necessary permits, certifications, or licenses.

Step 2: Apply to Be an S Corp

Once you’re incorporated on the state level, you will be able to apply to the IRS to transfer your now C corp status into an S corp status. To do so, first get a federal Employee Identification Number (EIN) by filling out IRS Form SS-4. Then fill out IRS Form 2553, Election by a Small Business Corporation. Be sure to act fast, because this form must be filled out within 75 days of establishing your business as a C corp.

It’s a good idea to work with an attorney or financial advisor as you go through this process, since they’ll have the know-how to help you navigate each step. They’ll also be aware of state laws, which may require you to file similar S corp forms on a state level.

Is an S Corp Better Than an LLC?

That depends! Ultimately, choosing to pursue an S corp status for your LLC comes down to how you want to structure your taxes and how you want to work with and manage shareholders. There is also a chance that neither of these designations are right for your business and you’re better off going with a sole proprietorship.

Running your own business is a great way to find career fulfilment, but it comes with a lot of big decisions. And because the S corp vs. C corp vs. LLC vs. sole proprietor is such an important one, you’ll probably want to run your options by a financial advisor if you’re not quite sure which way to go. That way, you’ll get a full picture of how each designation will affect your business, as well as how they fit (or don’t fit) with your goals and dreams as a business owner.

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This article is not intended to be financial advice.

Written by:

Laura Mueller