What Is an S Corp and When Should Your Business Make the Switch?

S corporation status is popular among small business owners for its tax advantages and limited liability protection. These can both be highly beneficial, especially once you pass a certain level of income and operational complexity.

But there are also significant limitations and potential drawbacks to owning an S corporation. If you’re thinking about forming one, here’s what you should know, including how they work, compare to other structures, and generate tax savings. 

Start With the Basics: What Is an S Corp?

An S corp, short for S corporation, is a business entity structure that lets your company pass its income, losses, deductions and credits through to shareholders for tax purposes. Instead of the business paying a corporate income tax on its earnings, shareholders report their portion of the entity’s activities on their personal tax returns.

S Corps Differ From C Corps in Key Ways

S corps are often compared to C corporations, or C corps, but there are key differences. The unique tax structure for S corps allows them to avoid double taxation, which applies to C corps. That fact alone can make an S corp a more advantageous choice for many small business owners. However, S corps also have shareholder and stock class restrictions that may be an issue if you want to grow beyond a certain scale.

Here’s a quick comparison of the two corporation types:

S Corp vs LLC: Making the Most of Liability Protection

Many small business owners begin operations as sole proprietorships or partnerships because they don’t require any paperwork to establish. As your business grows, it often becomes beneficial to upgrade to an entity that offers limited liability protection, which shields your personal assets from your business debts.

Entities that provide liability protection include corporations and limited liability companies (LLCs). However, because of the double-taxation issue C corps face, the initial choice often comes down to S corps and LLCs.

Here are the key differences between the two:

• Tax treatment: LLCs and S corps are both passthrough entities by default, but S corps have an added tax benefit: Shareholders can take part of their income as distributions rather than a salary and save on self-employment taxes.
• Ownership flexibility: S corps are limited to 100 shareholders, all of whom must be individual U.S. residents, estates or certain types of trusts. In contrast, LLCs have no restrictions on the number or type of owners, referred to as members.
• Compliance and formalities: As corporations, S corps are subject to more formalities, such as maintaining corporate bylaws, issuing stock and taking minutes during meetings. LLCs are generally easier to manage, requiring little more than an operating agreement and basic annual filings.

LLCs generally offer maximum flexibility and minimal administrative burden, making them a good choice if you want simplicity. S corps have more restrictions and increased compliance requirements, but they offer unique tax advantages.

S Corp Benefits and Tax Advantages: Avoid Double Taxation, Split Your Income

Beyond limited liability protection, the primary benefits of structuring your business as an S corp are tax related. First and foremost, S corps allow you to avoid the double taxation issue that C corps face.

More specifically, C corps pay a 21% federal income tax on their profits at the corporate level. Once they distribute the remainder to shareholders as dividends, the shareholders pay taxes on the amount again, either at ordinary income or capital gains rates.

In contrast, S corps pay zero federal income taxes on their profits at the corporate level. Instead, their income is only subject to ordinary income taxes at the shareholder level.

For example, say your business earns $200,000 in profit. Here’s how the taxes might work for a C corp:

• C corp pays 21% federal tax: $200,000 x 21% = $42,000
• $200,000 – $42,000 = $158,000 after federal taxes
• C corp distributes $158,000 as a qualified dividend
• Shareholders pay a 15% capital gains tax: $158,000 x 15% = $23,700
• Total taxes paid: $42,000 corporate + $23,700 personal = $65,700

Now, let’s play out the same scenario for an S corp:

• S corp earns $200,000 in profit and pays zero taxes on it
• S corp passes $200,000 in profit through to shareholders
• Assume an effective ordinary income tax rate of 20%: $200,000 x 20% = $40,000
• Total tax savings for the S Corp versus the C corp: $65,700 – $40,000 = $25,700

The second great tax advantage of S corps is the ability to split your income between a salary and distributions. Since salaries are subject to self-employment taxes but distributions aren’t, you pay less than you would otherwise.

For example, say your S corp earns $120,000 in profit. Based on industry standards, you decide a $70,000 salary is reasonable and take the remaining $50,000 as a distribution. You only owe the 15.3% self-employment tax on the $70,000 salary.

• $70,000 x 15.3% = $10,710

If you had operated as an LLC taxable as a sole proprietorship, the entire $120,000 would have been subject to self-employment taxes.

• $120,000 x 15.3% = $18,360
• Self-employment tax savings for the S corp: $18,360 – $10,710 = $7,650

Given these tax savings, many small business owners will consider changing their business structure to an S corp, but timing matters.

How To Know You’re Ready To Make the S Corp Election

Generally, the S corp election starts to make sense when your business income gets high enough that the potential payroll tax savings exceed the additional administrative and compliance costs you’re likely to incur.

While there’s no exact number, accountants often recommend you start considering the S corp election at around $40,000 to $80,000 in net annual income. Below that range, the extra costs and complications would probably outweigh any benefits you’d see.

Some of the additional expenses you might encounter when you make the S corp election include:

• Full-service payroll costs
• Accountant fees for tax planning and compliance
• Loss of the QBI deduction on the portion of your income paid as salary 

Beyond hitting a certain profitability threshold, S corp status can also make more sense if you’re reaching other milestones, such as taking on employees. If you’re already going to be running payroll, that’s one less cost to making the election.

Alternatively, you might be preparing for rapid growth or fundraising, whether through debt or equity. Lenders and investors would both often prefer to work with an S corp rather than a sole proprietorship or a partnership.

What To Evaluate Before Making the Switch

If you’re seeing several indications that S corp status might be worth it, here are some additional factors that should inform your decision:

• Reasonable compensation rules: The Internal Revenue Service (IRS) requires S corp owners to take a “reasonable salary” for the work they do. Setting it too low can trigger audits, penalties or adjustments. Your income must exceed this threshold before you can start taking distributions to save on payroll taxes.
• Ongoing compliance burden: S corps bring many additional administrative and tax obligations. While they can be manageable, they also shouldn’t be underestimated, and you’ll often require professional assistance.
• Impact on ownership structure: S corps are limited to 100 shareholders—none of whom can be partnerships or corporations—and one class of stock. These types of restrictions can disrupt your ownership structure and affect your ability to attract certain investors.
• State and local tax implications: Many states impose additional taxes and fees on S corps, or have unique rules that could impact your bottom line. In some locations, these might reduce or outweigh the payroll tax benefits of the S corp election, depending on your income level.

Ultimately, S corp status can be a viable way to save money in taxes, but it comes with many notable limitations and drawbacks that make the cost-benefit analysis complex. 

Once you’ve decided to form an S corp, there are additional steps to consider.

How To Form an S Corp

Interestingly, you can’t form an S corp from scratch. Instead, you must establish your business as an LLC or a C corp first, then elect S corp status by filing IRS Form 2553, Election by a Small Business Corporation.

You must have all owners sign the form and file it with the IRS before the 15th day of the third month of your first intended S corp year, whether that’s the current year or a future tax year.

For example, if you wanted an established company to become an S corp in 2026, you could submit Form 2553 on its behalf any time before March 15, 2026.

Meanwhile, if you formed a new LLC on June 21, 2025, and wanted to convert it to an S corp immediately, you’d have to file the election by September 4, 2025.

S Corp Requirements

To qualify for and maintain S corp status, you must meet the following IRS requirements:

• Be a domestic corporation
• Have only allowable shareholders, such as individuals, certain trusts and estates (not partnerships, corporations or non-resident aliens)
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (such as certain financial institutions or insurance companies)

Get S Corp Election Advice With Paro

S corps offer attractive tax advantages and liability protection, making them an attractive choice for many small and midsize business owners. However, those benefits come at a cost—and with extra responsibilities.

The S corp election brings additional expenses, and S corp owners must maintain a higher standard of financial hygiene to avoid compliance issues, such as having to keep track of salaries and distributions.

Fortunately, whether you’re still considering S corp status or looking for support after making the election, Paro’s network of experienced corporate tax advisors can help you devise and execute the optimal business entity and tax strategy.