What, exactly, is an S corporation?

Business people (and sadly even some accountants and lawyers who should know better) get confused about exactly what an S corporation is. So this is a good question.

In a nutshell, an S Corporation is a corporation, partnership or limited liability company that’s made an S election with the IRS.

And, yes, you did just read right. An S Corporation doesn't have to actually be a corporation. It needs only to be what the Internal Revenue Service considers an eligible entity.

You should therefore think about an S corporation not as a "legal entity" but rather as a tax accounting classification.

Just to go into this definition a bit further, the S election tells the IRS that the business wants to be treated under the rules of Subchapter S of the Internal Revenue Code.

While there are many complicated provisions in Subchapter S, the basic feature of an S corporation is easy to understand: S corporation taxable income or S corporation tax deductible loss is allocated to the S corporation owners based on their ownership percentages.

An S corporation that makes, say, $100,000 in profits pays no income taxes on that profit. Instead, the shareholders of the S corporation include the profit on their returns.

If two shareholders equally own an S corporation that makes $100,000, for example, each shareholder adds $50,000 of income to his or her return and then pays the tax on that $50,000 profit from the S Corporation.

Two quick final comments about choosing to operate as an S corporation: First, just to be clear on this point, small business owners use S corporations to minimize the amount they pay in payroll taxes. The S corporation minimizes amounts shareholder-employees pay in payroll taxes because the S corporation profit allocated to a shareholder isn't subject to payroll taxes.

And now a second comment: The catch with an S corporation is that the salary you set for a shareholder-employer such as the owner needs to be reasonable. A low salary might save payroll taxes temporarily, but the IRS should be able to successfully challenge such a salary. The 1120S tax return, which is what an S corporation files, makes it very easy to see when shareholder-employees are under-compensating themselves.

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