Businesses can take many legal forms — sole proprietorships, partnerships, limited liability companies (LLCs), and corporations, along with different flavors of each. One commonly used type of corporation is the "S corporation," which can both limit liability and give tax advantages to some businesses.
An S corporation is a regular corporation that has elected "S corporation" tax status. Being a corporation generally shields owners from the business’ liabilities. Being an S corporation offers this perk, plus the tax structure of a partnership. In a partnership (and an S corporation), all of the corporation’s profits and losses "pass through" to the owners, who report them on their individual income tax returns. The S corporation itself does not pay any income tax.
This avoids double taxation on profits and allows the offset of business losses with income from other sources. Also, unlike owners of LLCs, S corporation shareholders are not subject to self-employment taxes the way active LLC owners are. Though state laws vary, most states follow the federal model for S corporations and taxes.
There are, however, requirements placed on S corporations, including:
- The corporation cannot have more than 100 shareholders;
- Shareholders cannot live outside the US;
- Profits and losses must be accorded to owners in proportion with their ownership stake;
- Shareholders cannot deduct losses in excess of their "basis" in corporate stock (meaning they can’t deduct more than they invested); and
- The corporation cannot deduct fringe benefits given to employees who own more than 2% of the corporation.
Finally, the decision to elect S corporation status isn’t permanent. If the business becomes more profitable and there are tax advantages to being a regular corporation, S corporation status can be dropped after a certain amount of time.