What Is an S Corp? A Plain-English Explanation for Founders

An S corp is a corporation, or an LLC taxed as a corporation, that has elected to be taxed under Subchapter S of the Internal Revenue Code (IRC §§1361 to 1379). The election changes how the business is taxed. It does not change what the business is under state law.

That distinction trips up a lot of people. You cannot walk into the Delaware Division of Corporations and form an 'S corp.' You form a corporation (which is a C corp for tax purposes by default) or an LLC, get an EIN, and then file Form 2553 with the IRS. If the IRS accepts the election, the same legal entity is now taxed as an S corporation.

The name comes from the subchapter. A C corp is taxed under Subchapter C, an S corp under Subchapter S. Both are corporations for liability purposes, both have shareholders, directors and officers, and both file a federal return every year. The difference is who pays the income tax.

If you are comparing structures for a new startup, our longer piece on C corp vs S corp for startups covers the decision itself. This article answers the definitional question: what an S corp is, who can be one, and how the money actually works.

An S corp generally pays no federal income tax itself. It files Form 1120-S, an information return, and issues a Schedule K-1 to each shareholder showing that person's share of income, deductions and credits. The shareholders report those amounts on their own Form 1040 and pay tax at individual rates.

Three details matter in practice.

• You are taxed whether or not cash is distributed. If the company earns $150,000 and keeps it all in the bank, a 60% shareholder still reports $90,000 of income. Founders who reinvest every dollar can end up with a tax bill and no cash to pay it.
• Allocations follow share ownership, strictly. Income is allocated per share, per day. You cannot give one owner 80% of the profit and another 20% if they each own half the stock. LLCs taxed as partnerships can do special allocations; S corps cannot.
• Losses are limited by basis. A shareholder can deduct S corp losses only up to their stock and debt basis (IRC §1366(d)), and the at-risk and passive activity rules apply on top of that.

Compare that with a C corp, which pays a flat 21% federal rate on its taxable income and then taxes shareholders again when it pays dividends. Avoiding that second layer is the main reason S corps exist. The IRS notes one exception: an S corp can owe entity-level tax on certain built-in gains and excess passive income, which mostly affects companies that converted from C corp status.

To elect and keep S status, the company must meet every one of these tests, per the IRS and IRC §1361:

1. It is a domestic corporation, or a domestic entity eligible to be treated as a corporation (which includes most LLCs).
2. It has no more than 100 shareholders. A married couple and their estates count as one shareholder, and members of a family can elect to be treated as one.
3. Every shareholder is an allowable shareholder: an individual who is a US citizen or resident, an estate, certain trusts, or certain tax-exempt organizations. Partnerships, corporations, LLCs taxed as partnerships and nonresident aliens cannot own S corp stock.
4. It has only one class of stock. Differences in voting rights are allowed (IRC §1361(c)(4)), so voting and nonvoting common is fine. Differences in distribution or liquidation rights are not.
5. It is not an ineligible corporation, such as certain banks, insurance companies and DISCs.

These are not one-time tests. If a nonresident alien buys a single share, or the company issues a share class with a liquidation preference, the election terminates automatically on that date (IRC §1362(d)(2)). The company becomes a C corp mid-year and files a short-year return for each part. Once an election terminates, the company generally cannot re-elect for five years without IRS consent (IRC §1362(g)).

Any shareholder who works in the business must be paid reasonable compensation through payroll before the company makes profit distributions. The IRS says this directly, and it has authority to reclassify distributions as wages if the salary is too low.

This rule is where the tax savings live and where the audit risk lives. Wages are subject to Social Security and Medicare tax (FICA). Distributions of profit above the salary are not. So the incentive is to set the salary as low as possible, and the IRS knows it.

The IRS lists the factors it and the courts weigh when deciding what is reasonable:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• What comparable businesses pay for similar services

In plain terms, pay yourself roughly what you would have to pay someone else to do your job. A full-time owner of a consulting firm who takes a $20,000 salary and $180,000 of distributions is inviting a reclassification. We usually tell owners to document how they set the number (salary surveys, job postings, what the company pays its own staff) and to revisit it each year as profit changes.

Here is a simplified example for a single-owner consulting business with $200,000 of net profit before paying the owner. The 2026 Social Security wage base is $184,500 (IRS Publication 15); Social Security is 12.4% combined and Medicare is 2.9% combined.

As a sole proprietor or single-member LLC, the owner pays self-employment tax on 92.35% of net earnings: $200,000 x 92.35% = $184,700. Social Security applies up to the wage base: $184,500 x 12.4% = $22,878. Medicare applies to all of it: $184,700 x 2.9% = $5,356. Total self-employment tax: about $28,234.

As an S corp paying the owner a $100,000 salary, combined FICA is $100,000 x 15.3% = $15,300 (half withheld from the owner, half paid by the company). The rest of the profit flows through on the K-1 without payroll tax.

That headline number shrinks once you add real costs: a payroll provider, a separate Form 1120-S, state unemployment tax, and state-level S corp taxes (California, for example, charges S corps 1.5% of net income with an $800 minimum). The salary also reduces the owner's qualified business income for the §199A deduction, which the One Big Beautiful Bill Act made permanent at 20%. Run the numbers with your own salary figure before electing. When profit is modest, the fixed costs can absorb most of the savings.

Venture-backed companies almost never elect S status, and the reasons are structural rather than a matter of taste.

• Preferred stock is a second class of stock. Every priced VC round issues preferred shares with liquidation preferences. That alone breaks the one-class rule and terminates the election.
• VC funds are ineligible shareholders. Most funds are limited partnerships or LLCs. Partnerships and corporations cannot hold S corp stock.
• Foreign founders and investors are excluded. A nonresident alien co-founder, or an overseas angel, makes the company ineligible on day one.
• No QSBS. The Section 1202 exclusion applies only to stock of a C corporation. For stock issued after July 4, 2025, it can exclude up to $15 million of gain per issuer (with a tiered 50/75/100% exclusion at three, four and five years). Shares held while the company was an S corp do not count, and the clock starts only on C corp stock.
• Trapped losses. Early-stage startups lose money. In an S corp those losses flow to founders, who often cannot use them because of basis or passive-loss limits. In a C corp they stay as net operating losses the company can use later.

This is why investors and accelerators expect a Delaware C corp from the start. If you already have an S corp and plan to raise, revoking the election before the round is a routine step, but remember the five-year wait to re-elect and the fact that QSBS holding periods start only after conversion.

The S corp is a good tool for the right business. It fits best when all of these are true:

• The business is already profitable and expects to stay that way.
• All owners are US citizens or residents, and there is no plan to bring in fund investors.
• Profit comfortably exceeds a defensible market salary for the owners.
• The owners want cash out of the business each year rather than reinvesting everything.

Agencies, consultancies, fractional-executive practices and small software shops that sell services often fit that profile. A founder doing contract work while exploring a product idea may also use one for the consulting income, then form a separate Delaware C corp for the startup when it becomes real.

It is a poor fit for a pre-revenue company, any company that may raise a priced round within a couple of years, or a company with a foreign co-founder. If you decide an S corp fits, our step-by-step guide on how to start an S corp in Delaware walks through formation, the EIN and Form 2553.

An LLC is a state-law entity with flexible tax treatment. By default a single-member LLC is disregarded and a multi-member LLC is a partnership. It can elect to be taxed as a C corp (Form 8832) or an S corp (Form 2553, which handles the corporate classification at the same time).

A C corp is a state-law corporation taxed at 21% federally, with a second tax on dividends. It is the standard for venture-backed startups because it supports preferred stock, any number and type of shareholders, stock options and QSBS.

An S corp is either of the above with a Subchapter S election. It removes the entity-level income tax and can reduce payroll tax for owner-operators, in exchange for strict ownership limits.

If you are deciding between these for a new company, start with your fundraising plan, not the tax rate. The structure that fits how you will raise money is usually the right one, and the tax planning follows from there. This is general information rather than tax advice for your specific facts, so check your numbers with a CPA before filing an election.