What is an S Corporation? Comparison with LLC and Sole Proprietor
Introduction
Choosing the right business structure is one of the most important decisions a small business owner can make. It impacts everything from how you're taxed, to your personal liability, to your ability to raise funds. Among the most common structures are S Corporation (S Corp), Limited Liability Company (LLC), and Sole Proprietorship.
In this comprehensive guide, we’ll explain what an S Corporation is, how it functions, and how it compares to LLCs and sole proprietors. Whether you're starting a new business or considering a switch, this article will help you make an informed choice.
What is an S Corporation?
An S Corporation, or S Corp, is a type of corporation that meets specific Internal Revenue Code requirements. The name comes from Subchapter S of the IRS Code. It allows income to pass through to shareholders without being taxed at the corporate level—avoiding double taxation.
Key Features of an S Corporation:
- Pass-through taxation (income taxed only at shareholder level)
- Limited liability protection
- 100 shareholders max, all must be U.S. citizens or residents
- Can only issue one class of stock
- Must file Form 2553 with the IRS to elect S Corp status
How Does an S Corporation Work?
Once a business incorporates (as a C Corporation or LLC) and elects S Corporation status via Form 2553, it becomes eligible for pass-through taxation.
Here’s how it works:
- Business profits and losses pass through to shareholders’ personal tax returns.
- Shareholders pay taxes based on their percentage of ownership.
- The S Corp itself typically does not pay federal income taxes (some states do impose taxes).
- Shareholders who work for the company must be paid a "reasonable salary," which is subject to payroll taxes.
Benefits of an S Corporation
✅ Avoids double taxation
✅ Limited liability for owners
✅ May save on self-employment taxes
✅ Credibility with banks and investors
✅ Perpetual existence
Drawbacks of an S Corporation
❌ Strict eligibility requirements
❌ Limited number of shareholders
❌ More paperwork and compliance
❌ Must pay reasonable salary to shareholder-employees
❌ No foreign ownership allowed
S Corporation vs LLC
| Feature | S Corporation | LLC |
|---|---|---|
| Taxation | Pass-through | Default: Pass-through (can elect S Corp taxation) |
| Self-employment tax savings | Possible | Full net income may be subject to SE tax |
| Ownership restrictions | U.S. individuals only, max 100 | No restrictions |
| Stock options | One class only | Not applicable |
| Ongoing compliance | High (meetings, minutes, payroll) | Moderate |
| Management structure | Directors + Officers | Flexible |
An LLC offers more flexibility, but an S Corp can offer tax savings if the owner takes a salary and the rest as distribution (which avoids self-employment tax on distributions).
S Corporation vs Sole Proprietor
| Feature | S Corporation | Sole Proprietor |
|---|---|---|
| Legal entity | Separate | Not separate (personal and business are one) |
| Liability protection | Yes | No |
| Tax filing | Business files separately (Form 1120S + K-1s) | Files on Schedule C |
| Self-employment taxes | Can reduce via salary/distribution split | Pays SE tax on all net income |
| Cost to start | Higher (incorporation + filings) | Minimal |
| Compliance | High | Low |
Sole proprietorships are easy to start but offer no legal protection. S Corps involve more work but protect your personal assets and may offer tax advantages.
Should You Choose an S Corporation?
Consider forming an S Corporation if:
- You expect consistent profits.
- You want to limit self-employment taxes.
- You're fine with more compliance and paperwork.
- You’re a U.S. citizen or resident.
- You don’t need multiple classes of stock or foreign investors.
How to Form an S Corporation (Step-by-Step)
- Form a Corporation or LLC with your state.
- Get an EIN from the IRS.
- File IRS Form 2553 within 2.5 months of incorporation (or by March 15 for existing businesses).
- Comply with state and federal requirements, including payroll, taxes, and corporate governance.
Conclusion
An S Corporation can be a smart choice for small business owners looking to minimize taxes while enjoying liability protection. However, it comes with eligibility rules and extra compliance steps. Before making a decision, consult a tax advisor or accountant to assess what’s best for your unique situation.
Want to Set Up an S Corporation?
We can help you incorporate, elect S Corp status, and manage your compliance—so you can focus on growing your business. Contact us today for a free consultation!
FAQs
Q: Can an LLC be taxed as an S Corp?
Yes, an LLC can elect to be taxed as an S Corporation by filing Form 2553.
Q: When is the deadline to file for S Corp status?
You must file Form 2553 within 2.5 months of your business's formation date or by March 15 of the current tax year.
Q: Can an S Corp have employees?
Yes. In fact, shareholders who work for the business must be treated as employees and paid a reasonable salary.