What is an S corporation?

The term “S corporation” means “small business corporation,” and you can find the rules governing this type of entity in Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361 through 1379).

Essentially, S corporations can enjoy the regular benefits of incorporation while also taking advantage of a partnership’s tax-exemption opportunities.  

To put it more simply, an S corporation is an organization that elects to pass income, losses, deductions, and credits through to its shareholders for federal tax purposes. 

Regular corporations (or C corps) are subject to the corporate tax rate. Therefore, any money made by the corporation is subject to corporate income and dividend taxation at both the corporate and personal levels. Explaining it another way, the IRS taxes C corps both on the company’s income and any profits the shareholders may receive, which amounts to double taxation on the exact source of income.

However, S corps are pass-through or flow-through entities, which means the income can pass to the owners or investors of the company for tax purposes. This way, S corporations can avoid double taxation and only pay taxes on the income once, at the owner or investor’s personal rate. 

S corporations are the most popular business structure in the United States, especially for small businesses. According to the IRS, there are approximately 5 million S corps in the country (three times the amount of C corps). 

How does an S corp work?

As mentioned above, S corporations are flow-through entities, meaning shareholders can receive income from the company through salaries or distributions. The shareholder then reports the flow-through income and losses on their personal tax returns, where the IRS taxes the income according to the shareholder’s individual rates. 

This type of entity is also subject to certain limitations. For example, an S corporation may not have more than one hundred shareholders, all of whom must be individuals and United States citizens or residents. 

There are also restrictions on the sale or transfer of shares and the class of stock. Additionally, an S corporation must pay tax on certain built-in gains and passive income. 

Otherwise, an S corp functions much like a C corp because it is a for-profit company governed by state corporation laws. It also offers liability protection and ownership and management advantages and must observe formalities (such as having a board of directors, bylaws, and shareholder meetings), just like a C corp. 

Why would you choose an S corporation?

In general, incorporating your business can provide many benefits. An S corporation offers:

  • Protection of personal assets
  • Easier access to capital,
  • Perpetual existence of the company regardless of what happens to individual directors, officers, or shareholders, transferability of ownership
  • Tax savings,
  • The shelter of the “corporate veil,” which treats the company as a separate legal entity that limits how much liability rests on your shoulders. 

Incorporation can be beneficial for companies with multiple owners (whereas a business owned and operated by a single person may be better off organizing as a sole proprietorship, for example). 

An S corporation structure can be a worthwhile option to explore for any organization that would typically be a C corp but is eligible for S corp status (more on this and other requirements will follow below). 

So, why choose an S corp over a C corp?

Simple: to save money at tax time. Not every business will necessarily experience tax savings as an S corp, but your company could gain reduced taxes if it:

  • Meets S corp restrictions. 
  • Earns enough in net profit to pay its owner(s) a “reasonable salary” and at least $10,000 in distributions annually, and/or will realize enough tax savings to more than makeup for the payroll and accounting costs that result from making the S corp election.

Additional benefits of S corp status include the ability to pass net operating losses (NOLs) through to be claimed on the shareholder’s tax return and the fact that net income passing through from an S corp is not subject to payroll or self-employment tax. 

To help inform your decision about whether or not to become an S corp, you should also consider the following:

  • Cost and complexity of operating the business
  • Ownership control
  • Whether S corp status will reduce your taxes
  • Liability of the owners for the business’s debt, actions of the other owners, and for general liability

Having considered the above factors, you may next find yourself asking…

What are the disadvantages of an S corp?

While many of the advantages mentioned above can make S corp status very appealing for small business owners, there are also some drawbacks to keep in mind. 

For example, there are strict qualification requirements, including the number and type of shareholders and shares. Additionally, an S corporation may have only one class of stock, all shareholders must have equal rights to distributions, special allocations are not allowed, and some loans can cause termination of the S election. 

Furthermore, there are many corporate formalities, as mentioned above, a shareholders basis for deducting losses will only increase by a direct loan to an S corp, items such as net operating losses from C corps are not allowed to carry over to an S corp, and the shareholder pays taxes on all income, whether or not the company has distributed it. 

Finally, shareholders who hold greater than 2% of an S corp are treated as partners for fringe benefits. Many fringe benefits are not available, and filing taxes for an S corp taxes can be very complex (the corporation must file a federal return and have separate schedules for the tax due from owners). 

You’ll need to weigh this information against the potential advantages to your company of making the S corp election. However, if you find that the benefits outweigh the disadvantages, you should ensure that your organization is eligible to become an S corporation. 

What are the eligibility requirements for an S corporation?

In order to be eligible to become an S corporation, a company must meet the following requirements:

  • Be a domestic corporation
  • Have only allowable shareholders
    • May be individuals, certain trusts, and estates and
    • May not be partnerships, corporations, or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).

What’s more, the business must allocate profits and losses according to each owner’s interest in the business, and every shareholder must consent to the S election. The corporation must also continue to meet all of the above requirements to maintain S corp status. For example, if you elect as an S corporation but subsequently add a 101st shareholder, the IRS will revoke your S status, and your company will be double-taxed as a C corp.

How do you get started?

Before we outline the steps in becoming an S corporation, it’s important to clarify that you should consider this post a general guide, not specific legal advice. 

Having said that, we’ll continue. The first step is to make sure you have completed all the necessary preparations, including naming a board of directors who can meet at regular intervals and drafting corporate bylaws. Next, decide which kind of stock your company will issue and procure a certificate of incorporation. Finally, submit your documentation, file Form 2553 (Election by a Small Business Corporation), and file with a registered agent to receive official correspondence and documentation on behalf of your business. 

Although you can take this on by yourself, it is a complex process, and mistakes can lead to costly setbacks. Please reach out if you would like personalized assistance in becoming an S corporation. 

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