S-Corporations are companies which, as opposed to C-Corporations, do not pay any federal income tax on their earnings, except in a few exceptional cases. Instead, the earnings (or losses) are passed to the shareholders and will appear on their individual income tax reports.
The “S” comes from the subchapter of the Internal Revenue Code where the taxation laws are outlined. S-corps can actually be owned and operated by a sole proprietor after incorporating or starting an LLC in the state of residence and filing IRS form 2253 (link to instructions and form — found here).
One of the main reasons to do this is to avoid paying the 12.5% Social Security “self-employment tax” on the entirety of the business’s earnings for the year.
A reasonable amount of compensation must be paid out as income, which is subject to the self-employment tax, and the rest of it can be paid out as dividends, which will not be subject to the social security or Medicare taxes, but will be subject to income taxes.
Shareholders who do not perform services for the company may only receive dividend payments, but those who do will be counted as employees. There are certain limitations on who can form an S-Corporation, such as the number of shareholders and their citizenship status.
IRS Form 2253 — Found Here