Greg Corombos: Hi, I'm Greg Corombos. Our guest this week on Expert Insights is Tim Jensen, Manager of Customer Service at CT Corporation. As you know, we’ve spent a lot of time on Expert Insights discussing the importance of business formation and the various options like an LLC or a corporation. Today, we're going to look at what's known as an S corporation, or more commonly known sometimes as an S corp. And we'll discuss the benefits and challenges that go with establishing that as your formal entity. And Tim, thanks so much for being with us.
Tim Jensen: Yeah, thank you, Greg, it's great to be on with you again today.
GC: Well, let's create the distinction right away. What is an S corporation and how does it differ from a corporation?
TJ: This is a question I get a lot from new business owners when they're deciding on which entity type is the best for their situation. And there definitely can be some confusion about what makes an S corporation different.
First of all, every corporation that registers to do business with any Secretary of State starts off as a standard C corporation. It's actually a secondary filing with the IRS that makes it an S corporation. And the key feature that distinguishes an S corporation is the potential tax advantage it offers. It's called an S corporation, because it has elected to be taxed under subchapter S of the Internal Revenue Code, along with what is called a pass-through entity for tax purposes. Without this election, it's a standard for-profit C corp.
GC: And so what are some of the advantages of an S corporation? You mentioned the tax advantages, but what are some of the other advantages?
TJ: Yeah, there's several potential advantages to registering as an S corporation, and you'll certainly want to factor these in your decision to ensure it's the best option for your particular situation. First, they offer the same benefits as other formal business entities such as the limited liability protection for the personal assets of the owners, increased credibility for the business, easier access to capital, and the ability to deduct business expenses.
But S corporations also offer the flexibility to convert back to a standard C corporation, if needed. And one of the areas that this comes into play is the varying corporate tax rates, the higher the corporate tax rate, the better the benefit is for the S corporation, but as the Corporate tax rate goes lower, that's where business may want to make a decision on that. So, to revoke the S corporation it’s a simple filing request that's made to the IRS to have that original S corporation rescinded.
Finally, and this is probably the biggest factor for business owners when making this decision, with the pass-through taxation we discussed, the possibility of double taxation is eliminated.
GC: That's definitely huge. But I'm glad you came back around to that because I'm guessing some folks, if they're new to the idea of business formation, when you mentioned that it's taxed under Subchapter S of the Internal Revenue Code, making it a pass-through entity, might have been scratching their heads. What does that mean? So explain pass-through taxation.
TJ: With pass-through taxation, no corporate tax is paid on the company profits or losses. Instead, those profits and losses are passed through and reported on the owner’s individual tax returns. So, any tax due is then paid by the owners at their individual tax rate, not at the corporate tax rate. For S corporations, an informational corporate tax return is filed with the IRS, and that's form 1120S, but no tax is paid at the business level.
Because S corporations have this pass-through taxation. The possibility of double taxation that occurs with C corporations, which pay at both the business and individual level, is eliminated.
GC: An LLC, which we've talked about often on the podcast is also a pass-through entity. So why would someone choose an S corp over an LLC or vice versa?
TJ: Yeah, and this is a really good question, it’s something I've counseled business owners on. There are certainly some similarities between the two, such as the pass-through taxation, as you mentioned, limited liability protection, increased credibility for the business. But there's also some key differences you're going to want to consider.
So, for LLCs, they offer a more flexible management structure than S corporations. They are run by members or managers instead of officers and directors. They also include fewer ongoing formalities. However, based on the ownership structure, it can be more difficult to transfer that ownership when you decide to, you know, sell or get rid of your business.
S corporations also impose some very specific requirements on owners that are not required for LLCs. So it's a good idea to take all these into consideration when deciding which entity type fits your situation the best.
GC: Well, yeah, when you mentioned that LLC were a little more flexible, that means S corps are a little more rigid then. So, what are the requirements to be an S corp?
TJ: Yeah, and there are several requirements and all of them must be met. So first, the entity must be a corporation that's domestic to the United States in order to be eligible for any S corporation status. And then there are also some restrictions on the shareholders. So there has to be 100 or fewer shareholders. They must be either individuals, estates, or certain qualified trusts, but they cannot be partnerships, or corporations. And they all have to be U.S. citizens, which is one of the things that is often a sticking point for some business owners.
Also, all the shareholders must consent in writing, to approving an S corporation election. And then just a couple other things that go with the S corporation. They only allow for one class of stock, which can limit the options for owners.
And then lastly, certain corporations may be barred from becoming an S corporation. And these include certain financial institutions, insurance companies, and domestic international sales corporations.
GC: Those are some of the requirements obviously, for even becoming an S corp. But what are some challenges that come with actually forming an S corporation?
TJ: Yeah, and the first I'd say is just making sure that all the requirements we just discussed can be met, if this is the entity type that you want to choose. And obviously, if they can't, then you need to go in another direction.
But as I mentioned earlier, there also are ongoing corporate formalities that need to be handled. And these include holding and documenting annual shareholder meetings, electing officers, tracking shareholder information—that's important because again, all those requirements on the shareholders themselves—keeping up to date on any state impose requirements in the states that you're registered in, such as annual reports and other franchise taxes that may be due.
And then also, there are some states such as New Jersey, that do require you to file with their own department of revenue, in order to be recognized as an S corporation in their states. And if the state fines are not completed, the entity will still be taxed as a standard C corporation in that state, regardless of their federal status.
GC: Very important information and things that will hopefully help people from having a lot of headaches or pulling any hair out while they're forming an S corporation as the as their business formation. So, let's get to that process. How do I form an S corp?
TJ: Yeah, it's a fairly simple process. As I discussed earlier, S corporations are initially registered as C corporations. So the formation requirements would follow those, starting off by filing incorporation documents, which are typically called either the articles of incorporation or certificate of incorporation, filing those with the appropriate state agency and then paying any of the necessary state filing fees.
And then once that entity is incorporated the state, this is where we would go to get that election for the S corporation status. In order to do that, the business owner must file with the IRS, which is form 2553. And this is separate from the state filing that they've just completed.
And one important thing to note, to be eligible for the S corporation status in your first year of business, that form 2553 must be filed within two months and 15 days, which is essentially 75 days from the date of that initial formation or incorporation with the state. And if it's not completed within that timeframe, the election will not be in place until the following year.
GC: It probably won't surprise folks, Tim, that if there are a lot of boxes to check to be eligible for an S corp, and to some extent to form an S corp, there's also a few to check when it comes to ongoing compliance once you are an S corp. So what do we need to know there?
TJ: Yeah, like the other business entity types, an S corporation does have to follow the same state naming rules, you know, that may be in place. They do require a registered agent be listed, have to file their annual reports, and then keep any licenses and permits up to date that they may have. And also just maintain the good standing with the states they’re registered to do business in.
But there's also a couple other, and I mentioned ongoing corporate formalities earlier, you know those ongoing corporate formalities for S corps include holding a director and shareholders meeting every year; keeping corporate minutes in a corporate record book regarding those meetings and allowing shareholders to vote on major corporate decisions; obviously adopting and maintaining any updated bylaws; keeping a record of all the stock transfers, which is something I mentioned earlier; and then keeping your detailed financial records, which again are our best practices for any business.
And then finally, just adherence to the due date for annual statements and franchise taxes that may be due in the states are registered in. These vary by state. Some states connect the due dates to the anniversary date of the corporation or qualification, while other states that have specific due date, you know, for corporations and annual statements and a different day, maybe for their LLCs.
GC: Well, there are some very clear benefits to being an S corporation if in fact you qualify for it. But from investigating to becoming eligible to remaining compliance, there is quite a bit to keep track of here. So how can BizFilings help with all that?
TJ: Yeah, sure. Our service teams are always available to answer any questions you may have on anything that we've discussed so far today. We also have a wealth of resources available on our website to help you decide if this is the best option for your situation. I always suggest reviewing those to kind of get yourself up to speed, then when you do contact us you have some more targeted, specific questions, and allows us to help you a little bit easier.
And then when you've decided to move forward, we can assist with all the required filings to get your S corporation properly set up and, more importantly, help keep it in compliance going forward.
GC: Well, fantastic information as always, Tim, and it's great to know about all the different options that business owners can choose to put themselves and their business in the best position to succeed and to know that there's help to guide them along the way. So, thanks as always for being with us today.
TJ: Thank you again for having me, Greg.
GC: Tim Jensen is Manager of Customer Service at CT Corporation. I'm Greg Corombos reporting for Expert Insights. For more information on this topic, please visit bizfilings.com