What Is an S Corporation? A Guide to This Tax-Saving Business Structure

When starting a business, choosing the right legal structure can have a major impact on your taxes and liability. One popular option among small business owners is the S Corporation, or S corp for short. But what exactly is it, and how does it work?

In this post, we’ll break down what an S corporation is, how it helps business owners avoid double taxation, and what it takes to qualify.

What Is an S Corporation?

An S corporation is a special type of corporation that has elected to pass corporate income, losses, deductions, and credits directly to its shareholders for federal tax purposes. This is known as a pass-through taxation structure.

Instead of the corporation itself paying federal income tax on its earnings, the income flows through to the individual shareholders, who report it on their personal tax returns. This helps avoid the double taxation that standard C corporations face—where income is taxed at both the corporate and individual levels.

However, S corporations may still be subject to tax at the entity level on specific types of income, such as:

• Built-in gains (from converting from a C corp to an S corp)

• Excessive passive income, in some situations

  
  

Key Benefits of an S Corporation

• ✅ Avoids double taxation on corporate income

• ✅ Pass-through taxation means profits and losses go directly to shareholders

• ✅ Can help reduce self-employment taxes for owner-employees

• ✅ Offers credibility and limited liability protection like a C corp

  
  

Requirements to Qualify as an S Corporation

Not every business can become an S corp. To qualify, a corporation must meet these IRS requirements:

1. Be a domestic corporation

2. Have only allowable shareholders, including:

   • Individuals

   • Certain trusts and estates

   • (Excludes partnerships, corporations, and non-resident aliens)

3. Have no more than 100 shareholders

4. Have only one class of stock

5. Not be an ineligible corporation, such as:

   • Certain financial institutions

   • Insurance companies

   • Domestic international sales corporations (DISCs)

     
     

How to Become an S Corporation

If your business meets the qualifications, you can apply for S corp status by filing Form 2553: Election by a Small Business Corporation with the IRS.

Steps to Elect S Corporation Status:

1. Form your corporation (typically as an LLC or C corporation)

2. Ensure you meet all S corp eligibility criteria

3. Complete and sign Form 2553

4. File the form by the IRS deadline (usually within 75 days of incorporation or the start of the tax year)

   
   

👉 For detailed instructions, visit the IRS Form 2553 Instructions (PDF).

How S Corporation Shareholders Can Save on Self-Employment Taxes

One of the key tax advantages of an S corporation is the potential to reduce self-employment taxes—which cover Social Security and Medicare contributions—that sole proprietors and partners typically pay on their entire business income.

How does this work?

As a shareholder who also works as an employee of the S corp, you are required to pay yourself a “reasonable wage” for the work you perform. This wage is subject to payroll taxes (Social Security, Medicare, and withholding), just like any other employee’s salary.

However, any remaining profits distributed to you as a shareholder are treated as dividends or distributions—not wages—and are not subject to self-employment taxes.

Why is this important?

• By paying yourself a reasonable salary, you comply with IRS rules.

• By taking the rest of your earnings as distributions, you can significantly reduce the amount subject to payroll taxes, saving money on your overall tax bill.

• This strategy helps maximize your take-home income while staying within legal boundaries.

  
  

What counts as a “reasonable wage”?

The IRS expects your salary to reflect what you would pay someone else to do your job. Factors include:

• Your duties and responsibilities

• Time and effort devoted to the business

• Industry standards and comparable salaries

  
  

Note: Underpaying yourself can trigger IRS audits and penalties, so it’s important to strike the right balance.

Pro tip: Consult with a tax professional or accountant to determine a fair salary and optimize your tax savings while maintaining compliance.

Be Cautious About Assets in an S Corporation

While S corporations can provide tax advantages, you need to be careful about what types of assets are held within the entity—especially if those assets might be distributed to shareholders later.

Why it matters:

Distributing appreciated assets (such as real estate, equipment, or investments) from an S corporation to shareholders can trigger capital gains tax at the corporate level, even though S corps generally pass through income and avoid double taxation.

Here’s what happens:

• If the asset has appreciated in value and is distributed in-kind (rather than sold and the cash distributed), the S corporation must recognize the gain as if it sold the asset at fair market value.

• That gain then flows through to shareholders and is taxed on their personal returns.

  
  

Bottom line:

• S corps do not avoid gain recognition on distributions of appreciated property.

• If you plan to distribute assets in the future, it may be smarter to hold them in an LLC or other pass-through entity where this rule doesn't apply.

  
  

Planning tip: Work closely with a CPA or tax advisor when transferring or distributing assets from an S corporation to avoid surprise tax bills.

Is an S Corporation Right for You?

Choosing S corporation status can be a smart move if you're looking for a tax-efficient way to operate your small business while still enjoying the liability protection of a traditional corporation.

However, it’s not right for everyone. If your business:

• Plans to have foreign investors

• Wants multiple classes of stock

• Intends to retain profits within the company for growth

• Owns or plans to distribute appreciated assets

  
  

...then another structure (like a C corp or LLC) may be more suitable.

Final Thoughts

An S corporation is a powerful option for many small businesses looking to save on taxes while maintaining legal protections. But like all tax structures, it comes with rules, limitations, and risks—especially when it comes to holding and distributing assets.

If you're considering S corp status, don’t go it alone. Talk to a tax professional or business attorney to make sure it's the right move for your goals.

Need help choosing the right business structure?Speak to a qualified tax advisor or attorney to evaluate what's best for your long-term strategy.

The information provided in this blog post is intended for general informational purposes only and should not be construed as legal or tax advice. While every effort has been made to ensure the accuracy of the information, tax laws and regulations are subject to change, and individual circumstances may vary. For personalized advice and to ensure compliance with current tax laws, it is strongly recommended that you consult with a qualified tax professional, financial advisor, or legal counsel. The author and publisher of this blog assume no responsibility for any errors or omissions, or for any actions taken based on the information contained herein.