An S corporation or S Corp is a type of corporation that has elected a specific tax status with the Internal Revenue Service (IRS). This election enables the business to pass corporate income, losses, deductions, and credits through to the personal income of corporate shareholders without being subject to corporate tax rates.
This article explores the tax and other implications of an S Corp, which can help you determine if an S Corp is right for your small business. It also explains how to start the formation process.
How is an S Corp taxed?
S Corps are taxed under Subchapter S of the Internal Revenue Code (IRC), hence the name “S Corp”.
If you elect to S Corp status for your business, the business would not be subject to corporate federal income tax. Instead, business income and losses are passed through the company to the owners (shareholders). Having pass-through taxation means that S corporation income is not subject to double taxation like C corporation income.
The Tax Cuts and Jobs Act of 2017 provided further tax benefits to S Corps with the introduction of a 20% deduction on net “qualified business income” to eligible S Corp shareholders.
Most states recognize S Corps the same way the IRS does and tax shareholders accordingly, but there are some states that tax S Corps on profits above a certain limit. Importantly, certain states do not recognize S Corp status. It is best to consult with a tax advisor on how S Corps are taxed in the state where you do business.
Should I form an S Corp?
Here are a few reasons why small business owners decide to form an S Corp.
- S Corps offer limited liability protection. The owner’s personal assets are protected against losses, debt, and claims against the company.
- An S Corp offers pass-through taxation. As discussed above, no income taxes are paid at the business level. Profit or loss is passed through to the owners’ personal tax returns and any tax is reported and paid at the individual level.
- An S Corp election may lower your employment taxes. Reducing your overall employment tax liability is possible because you can be both the owner and an employee of your corporation. Shareholders can be employees of the business and can be paid salaries as employees. Employment taxes must be paid on the amounts received as salary. However, shareholders can also receive dividends from the corporation on which employment taxes are not paid.
- S Corps may have reduced taxable gains. If you choose to sell your business, your S Corp could have reduced taxable gains.
- S Corps can write off startup losses. An S Corp can write off many of the expenses and losses incurred during the early years of starting the business. These are offset against personal income.
What are some of the disadvantages of an S Corp?
- Complexity is a key disadvantage. Corporations are challenging and time-consuming for small businesses to set up and administer. S Corps must also adhere to the strict filing and operational processes of a C corporation. Becoming an S Corp can also be costly. To maintain compliance with tax and legal requirements, many business owners outsource to tax and legal professionals.
- Special limits. For instance, they cannot have more than 100 shareholders and each shareholder must be a U.S. citizen.
- S Corps can invite the attention of the IRS. Because S Corps can avoid paying payroll taxes by disguising shareholder salaries as corporate distributions, the IRS has historically paid close attention to how the S Corp pays its shareholder/employees before distributions are made. Any non-compliance with IRS rules on this matter and in other areas such as filing requirements, stock ownership, election, and more could result in termination of the S Corp. See our article on S corp vs C corp for more information.
What are the requirements for an S Corp?
To qualify for S Corp status your business must meet the following criteria:
- Be a domestic corporation
- Have only allowable shareholders. These may be individuals, certain trusts, and estates but may not be partnerships, corporations, or non-resident alien shareholders. Shareholders are limited in number to 100.
- Have only one class of stock
- Certain corporations may be barred from becoming an S Corp including certain financial institutions, insurance companies, and domestic international sales corporations.
How do I form an S Corp?
The formation requirements for an S Corp are the same as those for becoming a C corporation. Incorporation documents, typically called the Articles of Incorporation or Certificate of Incorporation, must be filed with the appropriate state agency and the necessary state filing fees paid.
Because an S Corp is an elected tax status, you must file for that status with the IRS — not your state. Use IRS Form 2553 for this step.
Maintaining your S Corp status
Like other business types, an S Corp follows state naming rules, requires a Registered Agent, files annual reports, needs to keep licenses and permits up to date, and must maintain good standing with states.
A few states such as California and Nevada require initial reports/statements to be filed and fees to be paid within the months following incorporation. Your online incorporation specialist or Registered Agent will let you know if your state has this requirement.
Other compliance responsibilities include:
- Holding a director and shareholders’ meeting every year
- Keeping corporate minutes (in a corporate record book) and allowing shareholders to vote on major corporate decisions
- Adopting and maintaining updated bylaws
- Keeping a record of all stock transfers
- Keeping detailed financial records
- Adherence to due dates for annual statements and franchise taxes. These vary by state. Some states connect due dates to the anniversary of the corporation’s formation or qualification. Other states set a specific due date for all corporation annual statements and another for all LLCs.
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