An S Corporation is a special small scale corporation that has no more than 100 shareholders. It is taxed similarly to a partnership, in that the corporation itself pays no federal income taxes. The shareholders receive dividends from the company and that is taxed as income. It enjoys many of the limited liability advantages of a regular C Corporation with these additional tax advantages.
C Corporations are separate from their owners. They pay federal and state taxes based on the profits of the company. Once taxes are paid, dividends are paid to the shareholders. Those dividends are again taxed as personal income for the shareholders. This can be seen as double taxation, an event that an S Corporation is able to avoid.
A corporation that chooses to be an S Corporation is taxed under Subchapter S with the Internal Revenue Service (IRS). All of the corporation's shareholders must sign Form 2553 "Election by a Small Business Corporation" and it must be submitted. Many states require separate state paperwork to be taxed as an S Corporation.
There are a few requirements that a company must meet to be eligible for S corporation structure. It must be a domestic corporation or limited liability company. There can be no more than 100 shareholders who must all be individual United States citizens. All profits and losses have to be doled out to the shareholders in a way that represents their individual interest in the business. If any of these requirements are not met, or change due to extenuating circumstances, the business will revert back to a C Corporation.
There are three major advantages to an S corporation. Business losses can be filed on a personal income tax return, which allows owners to offset personal income from other places. The taxable proceeds after the sale of an S corporation are less than with a C Corporation. Unlike a Limited Liability Company, owners, or shareholders, of an S Corporation are not responsible for self-employment taxes on their personal income tax return.
It is important to note that a business only remains an S Corporation as long as the initial requirements are met. If a business grows, it can revert to a standard C Corporation at any given point and be subject to those regulations. Many businesses choose to begin as S Corporations and use the tax advantages as long as possible before allowing growth to C Corporations.