An S Corporation (also known as “S Corp” or “subchapter S”) is a closely held corporation or LLC that has made an election and to receive different tax treatment from the IRS. S Corp status (small business corporation) is a tax designation, not a business entity type. You can’t incorporate as an S Corp. To be classified as one, you must apply to the Internal Revenue Service (IRS) after forming a corporation or LLC.
When you form a corporation, it is automatically classified as a C Corporation (or “C Corp”). If your corporation meets certain criteria, you can then file for S Corp status. In general terms, an entity the elects subchapter S status only pays taxes at the individual level, as opposed to a C Corp that pays taxes at both the entity and individual levels.
When you form an LLC (Limited Liability Company), it automatically becomes taxed as a pass-through entity – sole proprietorship for a single-member LLC or a partnership for a multi-member LLC. Just like the corporation, an LLC can elect to be taxed like an S Corp.
What are the Legal Requirements of an S Corporation?
The requirements to receive S Corp status are more stringent than those of a C Corp, but these are usually easy to meet for most small businesses. S Corporations must have 100 shareholders or less. The shareholders (or owners) of an S Corp cannot be another corporation, and all shareholders must be U.S. citizens or legal residents. The corporation must also only have one class of stock.
Owners of the corporation that are active in the business will also be employees and must take reasonable compensation.
How is an S Corporation Taxed?
S Corporation status allows small businesses to avoid double taxation, which happens when the corporation is taxed both as an entity. Then the business income received by the shareholders is taxed on the individual level. This taxation method evades the corporate tax rate, and the income from the business is instead taxed according to the shareholder’s income tax bracket.
The special tax status of S Corps is granted by the IRS and allows corporations to pass their corporate income, credits, and deductions through the entity to their shareholders. The entity pays no income taxes. Instead, the company’s shareholders divide the profits and losses between themselves and report it on their own personal income tax returns.
What are the Advantages of an S Corporation?
- Limited liability: Like a C Corp, an S Corp provides limited liability protection and separates the business assets and the personal assets of its shareholders.
- Tax benefits: As mentioned above, S Corporations are only taxed on the individual level through the income received by the shareholders. This is more favorable than the “double taxation” experienced by C Corporations. S Corp income is only taxed when paid out as salaries or dividends to shareholders. This difference in tax treatment can result in huge savings for an S Corp.
Additionally, profits generated by sole proprietorships and partnerships are all subject to self-employment tax (social security and medicare). With the S Corporation election, a portion of business profits may be issued as a dividend (or a distribution for an LLC) to the business owners, who are not subject to payroll taxes. Note that a reasonable salary must be taken before distributions are made.
What are the Disadvantages of an S Corporation?
- Shareholder restrictions: There are significant limitations on the nationality and number of shareholders who can own an S Corp. Unlike C Corps and LLCs, the owners of an S Corp must be U.S. citizens or lawful residents. C Corps and LLCs have virtually no limits to the number of members or shareholders, but for S Corps, there can only be up to 100 shareholders.
- Expenses: Establishing and maintaining an S Corp can be expensive. In addition to the initial incorporation expenses, the annual report and franchise tax fees in most states tend to run higher than those for an LLC.
- Voting Rights: Only one class of stock may be issued for an S Corporation, potentially limiting investor interest.
- Additional Tax Return: Entities that elect S Corporation status (or C Corporation) will require the filing of a separate tax return.
How Do you Form an S Corporation?
The very first step to starting an S Corp is to decide on a legal name for your business and conduct a preliminary name search to ensure the availability of the name. Then a corporation will need to file the Articles of Incorporation or an LLC will need to file the Articles of Organization with the Secretary of State. Filing the articles brings a number of questions like stock ownership, business address, tax year, registered agent, and so on.
After your corporation is formed, you should then apply for an Employer Identification Number (EIN) through the IRS. This is a unique number assigned by the IRS to identify a business entity for tax purposes.
To officially become an S Corp, you will need to complete and file IRS form 2553 within 75 days of your corporation formation. There is a penalty for filing an S Corp election outside this time frame, but the IRS provides relief for late filing in certain circumstances.
If you have an operating agreement, the subchapter S tax election should be noted.
If you choose to form an S Corp, you should strongly consider seeking professional advice to understand whether the accounting rules will provide any potential tax advantages and ensure everything is filed correctly.
Apply for S Corp Status: https://www.irs.gov/forms-pubs/about-form-2553
S Corp Late Election Relief: https://www.irs.gov/businesses/small-businesses-self-employed/late-election-relief