What Is an S Corp?

Every business has two layers most owners mentally merge into one. The first layer is legal: your state forms an LLC or a corporation, and that entity is what signs contracts and shields your personal assets. The second layer is tax: the IRS decides how the entity's profit gets taxed, and that classification can be changed by election.

"S corp" lives entirely in the second layer. A single-member LLC is taxed as a sole proprietorship by default and a multi-member LLC as a partnership; a corporation is taxed as a C corporation by default. Filing Form 2553, signed by all shareholders, tells the IRS to tax the same entity under Subchapter S instead. Nothing about your legal structure changes. Your liability protection comes from the LLC or corporation, not from the S election.

The election has real deadlines and a specific filing process, which live in our step-by-step guide to how to set up an S corp. This page stays on the definitional question: what the thing is and whether it is even the right tool for you.

An S corporation is a pass-through. The company files an informational return, Form 1120-S, and issues each shareholder a Schedule K-1 showing their share of profit or loss. Shareholders report that share on their personal returns and pay tax at their individual rates, whether or not the cash was actually distributed. The corporation itself generally owes no federal income tax.

Two narrow exceptions exist at the entity level: the built-in gains tax and the excess net passive income tax. Both generally matter only for S corps that were previously C corporations, so a freshly formed LLC that elects S status rarely touches either. They are worth knowing about mainly so "no corporate tax" does not read as an absolute.

One more concept earns a paragraph because it bites owners who ignore it: basis. Your stock basis is roughly what you put into the company, increased by the income that passes through to you and decreased by losses and distributions. Distributions are generally tax-free only up to your basis; take out more than your basis and the excess is taxed as capital gain, and losses beyond basis get suspended rather than deducted. Good bookkeeping tracks basis every year; bad bookkeeping discovers it during an audit.

A sole proprietor pays self-employment tax of 15.3% on 92.35% of business profit: 12.4% for Social Security and 2.9% for Medicare. An S corp owner instead splits the profit into two streams. The salary stream runs through payroll and pays the same Social Security and Medicare taxes any W-2 wage does. The distribution stream pays neither. That gap, payroll tax avoided on the distribution slice, is the entire savings engine. Income tax is unchanged; you pay ordinary income tax on both streams either way.

The catch that makes this legal rather than abusive: the IRS requires shareholder-employees to take reasonable compensation, meaning a salary in line with what similar businesses pay for similar work, before taking distributions. Set the salary unreasonably low and the IRS can reclassify your distributions as wages and bill you the back payroll taxes plus penalties. Where that line sits is its own topic, covered in depth in our guide to the S corp reasonable salary rules.

One near-wash worth naming: sole proprietors deduct half of their SE tax, and an S corp deducts the employer half of payroll taxes, so the two structures largely mirror each other on that point. The real difference lives in the distribution slice, which is why the next section just runs the numbers.

Two honest footnotes on this math. First, a lower salary means lower Social Security earnings on your record, which can affect future benefits; the savings are not free, they are a trade. Second, the qualified business income deduction interacts with this: your W-2 salary is not QBI, so shifting profit into salary can shrink a deduction worth up to 20% of qualified business income. The interplay is exactly the kind of thing a generic example cannot settle. Run your actual numbers in the S corp savings calculator, then pressure-test the result with a CPA.

Congress built the S election for genuinely small, simple ownership structures, and the eligibility rules enforce that. To elect and keep S status, the business must meet all of these tests:

• Domestic entity: a US corporation, or a US entity like an LLC that is eligible to be treated as a corporation for tax purposes.
• No more than 100 shareholders: spouses and certain family members can be counted together as one shareholder for this test.
• Only eligible shareholders: individuals who are US citizens or residents, certain trusts, and estates. Partnerships, corporations, and nonresident aliens cannot own S corp shares.
• One class of stock: every share must carry identical rights to distributions and liquidation proceeds. Differences in voting rights are allowed; a preferred class is not.
• A permitted tax year: generally the calendar year, unless the corporation establishes a business purpose for a fiscal year or makes a special election.

If your business has partners rather than a single owner, the eligibility rules and the payroll math both shift; our comparison of partnership vs S corp covers that fork. And the election paperwork itself, Form 2553 and its deadlines, is covered step-by-step in how to set up an S corp.

Plenty of owners elect S status because a video told them to, then pay for payroll and an extra tax return that save less than they cost. The honest disqualifiers:

• Profit is too low. Illustration: at $50,000 of profit, self-employment tax runs about $7,065. If a reasonable salary for the work is $40,000, S corp payroll taxes are about $6,120, a gross saving of under $1,000, which the added payroll and tax prep costs erase and then some. Below that neighborhood, keep the default and revisit when profit grows.
• Almost all profit is a fair wage for your labor. If a reasonable salary for what you do consumes nearly all the profit, there is no meaningful distribution slice to save on.
• You plan to retain and reinvest heavily, or raise investor money. Pass-through treatment taxes you personally on profit you leave in the business, and the one-class-of-stock and eligible-shareholder rules block preferred shares and entity investors. Businesses on that path often belong in C corporation territory instead.
• The QBI interaction eats the benefit. Because your own W-2 wages are not qualified business income, shifting profit into salary can shrink a deduction worth up to 20% of QBI, which offsets part of the payroll tax savings for some owners.
• Your state taxes S corps at the entity level. Some states impose franchise or entity-level taxes on S corporations that claw back part of the federal savings. California is the headline example; if that is you, start with how to set up an S corp in California before deciding.
• You will not run payroll discipline. The election obligates you to real payroll, filings, and a reasonable salary. Skipping those is how the savings turn into penalties.

Remember the framing from section one: this is not a contest between three kinds of company. The LLC column is a legal entity at its default tax treatment; the other two columns are tax classifications that a legal entity can hold.

Each cell above is a summary, not the full story. The LLC-vs-S-corp decision gets its own deep treatment in our LLC vs S corp guide, multi-owner businesses should read partnership vs S corp, and once an election is in place, even routine questions change shape, like whether an S corp gets a 1099.