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Setting up your business as an S corp can help you reduce your tax liability and protect your personal assets.
Leaving your nine-to-five to start your own business is a big decision, but it’s only the first step on your journey. Once you become an entrepreneur, you have numerous decisions to make. For example, you must choose a location, implement a hiring process, and settle on traditional and digital marketing strategies.
Selecting a business structure is one such crucial decision you’ll need to make early on. If you’re considering incorporating, you have several options, including to set up as an S corporation. We’ll explain S corporations and their pros and cons to help you decide on the right business structure for your endeavor.
An S corporation, often called an S corp, draws its designation from Subchapter S of the tax code. To start an S corp, a small business owner would file articles of incorporation in the state where it’s headquartered and then file for S corporation status with the IRS. While an S corp shares similarities with a C corporation, distinct income tax regulations and self-employment tax benefits distinguish the two structures.
Forming an S corporation is a strategic business decision that extends beyond simple paperwork. Incorporating protects your personal assets from business liabilities, provides substantial tax advantages and establishes credibility with customers, vendors and financial institutions.
Before setting up an S corp, you must apply for an employer identification number (EIN). An EIN lets you hire employees, open a business bank account and pay small business taxes.
Forming an S corp brings significant benefits to a business owner. Consider the following advantages:
Like an LLC, an S corp does not pay taxes at the corporate level. Any income or losses are reported only on the business owner’s personal income taxes. As a result, business owners avoid the double taxation that affects C corporations.
Because net losses are “passed through” as well, the individual shareholder may be able to reduce their tax liability by offsetting other income with any S corp losses.
However, there is an important caveat related to compensation management: Any shareholder who works for the company must pay themselves reasonable compensation. This means the shareholder must receive wages comparable to what similar roles pay in your industry and geographic location. According to IRS guidelines, factors including training, experience, duties, time devoted to the business, and comparable salaries determine reasonable compensation. Failing to meet this standard may result in the IRS reclassifying distributions as wages, potentially triggering penalties and back taxes.
According to the IRS, S corps are “considered by law to be a unique entity, separate and apart from those who own it.” The owners of an S corp have limited liability for the company’s actions. This means owners can’t be held responsible for the company’s actions or debts unless the business owners have signed a personal guarantee.
S corporation shareholders who work in the business are classified as employees for tax purposes, not self-employed individuals. This distinction creates substantial tax savings. While LLC members typically pay the full 15.3 percent self-employment tax on all business income, S corp owner-employees only pay Social Security and Medicare taxes on their W-2 wages. Any remaining profits distributed as dividends avoid self-employment tax entirely, potentially saving thousands of dollars annually for profitable businesses.
If you plan to sell your business in the future, an S corp is attractive for yet another reason: When you sell the company, your capital gains tax treatment can be more favorable than with a C corporation sale. S corp stock sales typically qualify for long-term capital gains treatment after holding the stock for more than one year, with federal rates ranging from 0 to 20 percent depending on income levels, plus a potential 3.8 percent net investment income tax for high earners.
An S corp is an excellent option if you plan to build a lasting business rather than a side hustle that you plan to sell in a few years. Unlike an LLC, an S corp has an unlimited life span.
Your business maintains perpetual existence, continuing operations regardless of changes in ownership, management or shareholders. This permanence provides stability for long-term contracts, lending relationships and business partnerships. The company persists even if founding shareholders retire, sell their shares or pass away, ensuring business continuity for employees, customers and stakeholders.
With an S corp, ownership is easily transferred through the sale of the company stock. Additionally, if you determine that S corp status no longer suits your business needs — perhaps due to growth requiring more than 100 shareholders or international investors — you can revoke the election by filing a statement with the IRS, signed by shareholders holding more than 50 percent of the stock.
When selling company stock, you will need to structure a stock purchase agreement that formally transfers ownership of your company’s stocks between two parties.
There are many benefits of setting up an S corp, but you should be aware of these disadvantages:
If you think an S corp may be the right legal structure for your business, consult a business attorney who can inform you of your options and recommend the appropriate next steps based on your situation.
If you’re on the fence about setting up an S corp, there are other options to consider.
“Business owners should think about entity structure because it’s really key,” said Candice Caruso, SVP, Chief Business Banking Officer at WSFS Bank. “An entity structure that may have served you well at the beginning of your business may not be the right structure as you continue to grow and evolve. It’s important to reassess that over time and see what advantages [other structures] may provide you.”
Here’s a breakdown of different types of business structures:
Business structure | Ownership | Owner’s liability | Tax |
|---|---|---|---|
S corporation | 1+ people | Not held personally liable | Corporate tax |
C corporation | 1+ people | Not held personally liable | Corporate tax |
LLC | 1+ people | Not held personally liable | Self-employment tax |
Partnership | 2+ people | Held personally liable unless structured as a limited partnership | Self-employment tax |
Sole proprietor | 1 person | Held personally liable | Self-employment tax |
Here’s more information about these business structures:
If you plan to dissolve a partnership, both you and your former business partner can be sued during and after the dissolution process.
An S corp gets its name because it is taxed under Subchapter S of the Internal Revenue Code, making it a “pass-through” business. This means the company’s income isn’t taxed at the corporate level but “passes through” to the shareholders.
According to the IRS, businesses must meet the following requirements to qualify for S corp status:
To form an S corporation, begin by incorporating your business in your state by filing articles of incorporation with the secretary of state and paying the required filing fees. Next, obtain an EIN from the IRS if you haven’t already. Within 75 days of incorporating (or by March 15 if electing for the current tax year), file Form 2553, Election by a Small Business Corporation, signed by all shareholders. The IRS typically responds within 60 days with an acceptance or rejection letter. If approved, your S corp election becomes effective on the date specified in your filing, usually the beginning of the current tax year if filed timely.
An S corp typically makes sense when your business generates sufficient profit to pay yourself a reasonable salary plus additional distributions. A common rule of thumb suggests considering S corp status when your net business income exceeds $60,000 annually, as the self-employment tax savings often outweigh the additional compliance costs at this threshold. C corps suit businesses planning to raise venture capital, go public, or expand beyond 100 shareholders. LLCs work well for businesses holding appreciating assets like real estate, or those preferring simpler administration without the formal requirements of corporate governance.
Yes, you can switch from an S corp to a C corp through voluntary revocation or automatic termination. For voluntary revocation, file a statement with the IRS signed by shareholders owning more than 50 percent of the stock, specifying the revocation date. The change typically takes effect the following tax year unless you specify a prospective date. Be aware that once you revoke S corp status, you generally must wait five years before re-electing it, unless the IRS grants special permission. Automatic termination occurs if you violate S corp requirements, such as exceeding 100 shareholders or issuing a second class of stock.
