When incorporating your business as a regular corporation, also known as a C corporation, you get the benefit of limited liability, but you potentially subject yourself to double taxation. If you remain a partnership or sole proprietorship, you avoid double taxation but don't get the benefit of limited liability. An S corp is still a corporation, it's just taxed differently. The federal government enacted S corp legislation in 1958 so that small businesses could select an entity that granted limited liability and avoided double taxation.
S Corp Taxation
The main reason that corporations make the S corp election is to take advantage of "pass-through" tax treatment. With a C corporation, the profits of the company face two layers of taxation. First, the corporation pays the corporate income tax. Then, when the C corporation distributes the profits to shareholders, the shareholders have to pay personal income taxes. With an S corporation, the income or losses from the corporation pass through to each shareholder's personal income tax return, similar to how sole proprietorship or partnership income is treated. To become an S corporation for tax purposes, you have to file Form 2553 with the IRS.
S Corp Requirements
Not every corporation can elect to be an S corporation because S corps must meet certain criteria. First, the company can't have more than 100 shareholders. However, special exceptions exist that allow certain family members to be counted as one shareholder. Second, people who aren't U.S. citizens or U.S. residents can't be shareholders. Also, most entities such as corporations, partnerships and many trusts are prohibited from owning S corp stock. Finally, the corporation cannot have more than one class of stock, though differences in voting rights can exist between shares. Violating these requirements invalidates the S corp election.
S Corp Benefits
Though some companies that elect to be taxed as an S corporation could achieve similar tax benefits by being an limited liability corporation, many states restrict the types of businesses that can use the LLC entity choice. S corporations do not have any similar restrictions. For example, if state law prohibits a bank from using an LLC entity choice, the bank could still take advantage of pass-through tax treatment by electing S corp tax status, assuming it meets the requirements.
S Corp Estate Planning Benefits
S corporations allow more flexibility for people who want to maintain control of the corporation while transferring more ownership to others because you can have voting shares and nonvoting shares without violating the one-class of stock rule. For example, if you want to start transferring ownership of your business to your children and grandchildren to avoid estate taxes, but don't trust them to run the business, you can transfer nonvoting stock so that you still have total control.