An S corporation or S-corp is a business entity that is exempt from paying federal income taxes other than tax on certain capital gains and passive income. The S corporation elects to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code by filing form 2553 with the Internal Revenue Service (IRS) and is viewed as a partnership or sole proprietorship for taxation purposes. This eliminates the disadvantage of double taxation of corporate income and shareholder dividends.

All business profits are divided among and "passed through" its owners who then report their share of the corporation's separately stated items of income, deduction, loss, and credit and also their share of non-separately stated income or loss on their own individual income tax returns. For regular corporations or C corporations, the company itself is taxed on business profits, and owners pay individual income tax only on money received from the corporation as salary, bonuses, or dividends.

Entrepreneurs seek to protect their personal assets from business claims and have business profits taxed on their individual tax returns; hence the S corporation is the most popular legal structure among small business owners. Another attractive characteristic of the S corporation is if you sell your S corporation, the taxable gain on the sale of the business can be less than it would have been if you had operated under C corporation status. Additionally, S corporation shareholders are not subject to self-employment taxes. These taxes add up to more than 15% of income and are used to pay Social Security and Medicare taxes.

However, there are drawbacks. For example, S corporations are only authorized to issue one class stock, all stockholders must be either a citizen or resident of the U.S., and there can only be 75 stockholders. In the globally competing business world, the S corporation is denied conducting business with foreign investors, issuing preferred and common stock and stockholders are limited. Also, S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation. Failure to continually meet these eligibility requirements results in the corporation being reverted to C status. Therefore, the corporation has to pay particular attention to detail and implement effective recordkeeping practices. Once a corporation is reverted to C status it cannot file for S status for another five (5) years, which can be a costly error.

Interestingly, S corporation is not permanent. The corporation can voluntarily revoke its status if it finds that S status is no longer beneficial. This can be done simply by notifying the IRS. Also, the IRS will terminate S corporation status if the income from passive investment is greater than 25% of its total income for more than three (3) consecutive years.

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