What is S Corporation?

How it works

An S corporation is a regular US corporation (formed under state law like any C corporation) that has filed an election with the IRS to be taxed under Subchapter S of the Internal Revenue Code. The election makes it a pass-through: the corporation itself owes no federal income tax (per PwC US Corporate Taxes-on-Corporate-Income), and profits flow through to the shareholders, who report them on their personal Form 1040.

Eligibility is strict (per PwC US):

• 100 shareholders or fewer.
• All shareholders must be US citizens, US resident aliens, certain trusts, estates, or tax-exempt entities. Non-resident aliens are categorically excluded.
• One class of stock only (with limited voting / non-voting variations allowed).
• Must be a domestic corporation.

The election is made by filing Form 2553 with the IRS, signed by all shareholders. The deadline is roughly 75 days into the tax year for which the election is to take effect (with relief procedures for late filers).

The S-corp tax angle

The principal tax draw is the payroll-tax split. An S-corp shareholder who works in the business takes part of their compensation as W-2 salary (subject to FICA / Medicare = 15.3% combined employer + employee) and the rest as distributions (free of payroll tax). A C-corp owner-employee can't do this; LLC self-employment income hits SE tax on the full net.

The catch: the IRS requires the salary to be reasonable compensation for the services rendered. A founder paying himself $20,000 of salary plus $400,000 of distributions on $420,000 of profit is asking for an audit and back-payroll-tax assessments. Reasonable comp is benchmarked against role, region, hours, and industry — typically 40–60% of total compensation in well-known cases.

S-corps file Form 1120-S by 15 March (per PwC US) and issue Schedule K-1 to each shareholder.

Why non-residents are excluded

Subchapter S was designed in 1958 as a small-business shelter for domestic owners. Allowing foreign shareholders would let foreign income flow through to non-residents without any US-resident ever being the taxable bearer. To keep the regime watertight, the statute simply bars non-resident-alien ownership.

For a non-resident founder, the choice is therefore between:

• LLC (default disregarded or partnership, federally pass-through) — flexible, cheap, no S-corp tax angle, foreign-friendly.
• C corporation (taxed at 21% federally + state, dividend WHT layered) — needed for QSBS / VC fundraising structure, slightly more expensive operationally.

Examples

• US co-founder duo, $400,000 profit each. Form an LLC, elect S-corp via Form 2553. Each takes ~$130,000 of W-2 salary (reasonable comp for their role), the rest as K-1 distributions. FICA hits the salary only — saving meaningful payroll tax compared to a Schedule C / partnership where SE tax applies to the full net.
• French founder forms a Delaware corp and elects S. The election is invalid the moment he signs Form 2553 — non-resident shareholders are barred. The IRS will reject it; if it slips through, the election is revoked retroactively, and the entity pays C-corp tax on every prior year of profits.

Common mistakes

• Adding a foreign spouse / shareholder mid-year. Instantly terminates the S election. The corporation reverts to C-corp status from that day; back-tax exposure builds quietly if not caught.
• Underpaying reasonable comp. Audit-prone area; the IRS reclassifies low-salary distributions as wages with full FICA + penalties.
• Missing the 75-day Form 2553 window. Late S-elections require IRS relief; not granted automatically.
• Treating S-corp tax savings as universal. With low profit (under approximately $60,000), the additional payroll setup, accounting and 1120-S costs eat the savings. The break-even is usually around $60,000–$80,000 of profit.