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[Prefer to listen? You can find a podcast version of this article here: E260: What Is an S-Corp and How Do You Set One Up?]

If you’re a small business owner or self-employed professional, you’ve probably heard about the S-corporation—often called an S-corp. Maybe a friend mentioned they saved money on taxes after switching to one. Or maybe your accountant suggested it as a next step as your income grows.

S-corps can offer significant tax advantages, but they also come with rules, responsibilities, and deadlines you need to understand.

What Is an S-Corp?

An S-corp is not a business entity in itself. Instead, it's a tax election.

When you create a business, you typically form it as a limited liability company (LLC) or a corporation (C-corp) at the state level. Then, if your business meets certain criteria, you can choose to be taxed as an S-corporation by filing Form 2553 with the IRS.

The S-corp designation allows your business to avoid double taxation—profits are passed through to the owners’ personal tax returns, similar to an LLC. But unlike a sole proprietorship or partnership, an S-corp can also reduce the amount of income subject to self-employment tax.

Why Choose S-Corp Status?

The biggest draw of an S-corp is its potential to save on taxes.

When you operate as a sole proprietor or an LLC taxed as a sole proprietorship, all your business profits are subject to self-employment tax—currently 15.3% for Social Security and Medicare.

But with an S-corp, you're required to pay yourself a reasonable salary (which is subject to payroll taxes), and any remaining profit can be distributed as dividends, which are not subject to self-employment tax. This can result in significant tax savings, especially for high-income business owners.

These dividends are simply direct payments transferred from your business account to your personal account.

That said, "reasonable salary" is a legal requirement, and the IRS pays attention to this. Your salary should reflect what someone in your industry and role would earn.

Who Qualifies for S-Corp Status?

Not every business can become an S-corp. The IRS has specific eligibility requirements:

• You must be a domestic corporation or LLC.
• You can have no more than 100 shareholders.
• Shareholders must be U.S. citizens or residents (no partnerships, corporations, or non-resident aliens).
• You can only issue one class of stock.

If your business meets these criteria, you’re likely eligible to elect S-corp status.

How to Set Up an S-Corp

Here’s how to go from business idea to an operational S-corporation.

1. Form Your Business Entity

The first step is to form a legal business entity at the state level—typically an LLC or a C-corporation. This involves:

• Filing formation documents with your Secretary of State.
• Choosing a unique business name.
• Paying the appropriate filing fees.
• Designating a registered agent.

In many cases, forming an LLC is the simpler and more flexible route, and you can later elect S-corp status with the IRS.

Obtain an EIN

Once your business is formed, apply for an Employer Identification Number (EIN) from the IRS. You’ll need this for tax filings, payroll, and opening a business bank account.

You can apply for an EIN online on the IRS website—it’s free and takes just a few minutes.

3. Elect S-Corp Status with the IRS

Now comes the crucial step: filing IRS Form 2553, “Election by a Small Business Corporation.”

This form must be filed:

• Within 2 months and 15 days after the beginning of the tax year in which the election is to take effect, or
• At any time during the tax year prior to the year the election is to take effect.

If you miss the deadline, you may still be able to request late election relief, but it's best to file on time.

4. Set Up Payroll and Compensation

Once you’re an S-corp, the IRS requires that you pay yourself a reasonable salary. That means setting up payroll, withholding income and payroll taxes, and issuing W-2s.

This is a critical part of remaining compliant as an S-corp. You’ll likely want to use a payroll provider to handle this.

5. Keep Clean Financial Records

You’ll need to separate personal and business finances, keep accurate books, and file the correct tax forms. S-corps file a corporate tax return each year (Form 1120-S) and issue a Schedule K-1 to each shareholder, showing their share of the company’s income.

Many business owners work with a tax pro or bookkeeper to ensure this is done right.

Ongoing Responsibilities of an S-Corp

While S-corps offer tax advantages, they come with extra administrative work. Here’s what you’ll need to maintain:

• Annual corporate tax return (Form 1120-S)
• Reasonable salary with payroll reporting and tax withholding
• State compliance (annual reports, franchise taxes if applicable)
• Accurate bookkeeping
• Proper distributions and documentation

Failing to meet these obligations could result in penalties—or worse, revocation of your S-corp status.

Is an S-Corp Right for You?

An S-corp can be a smart move if:

• Your business earns more than you need to pay yourself as a salary.
• You’re paying a lot in self-employment taxes.
• You’re organized and able to keep up with the administrative requirements (or have professionals to help).

But it’s not always the best option for new or low-income businesses, where the savings don’t outweigh the extra complexity.

Please note: I've seen a lot of business owners elect to become an S-corp because they saw all sorts of information online telling them they can save "a lot" on taxes. Many of these business owners would be better served by keeping their Schedule C tax status as an LLC.

There are a lot of businesses that have elected S-corp status and now have a lot more hassle to deal with, and they aren't saving much (or anything) on taxes.

Additionally, some of the advice telling people to become an S-corp assumes an artificially low salary, which can open you up to audit risk.

Bottom line: think carefully before becoming an S-corp and get professional advice before making the change.

Final Thoughts

The S-corp election is one of the most effective tools for reducing tax liability as a growing business owner.

It’s not for everyone, but when used correctly, it can unlock thousands of dollars in tax savings every year.