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What is an S Corporation?

s corporation
Most S corporations have fewer than 10 employees.
Credit: Konstantin Chagin | Shutterstock

Business owners have a number of business structures to choose from when setting up their companies. One popular type of small business structure is an S corporation.

Eligibility requirements

An S corporation, also referred to as a Subchapter S of the first chapter of the Internal Revenue Code, uses a tax structure that gives companies the limited liability benefits of being a corporation with the tax advantages of a partnership or LLC.

Requirements for a business to become an S corporation include being a domestic company, having no more than 100 shareholders and issuing only one class of stock. Shareholders can only include individuals, certain trusts and estates and cannot contain partnerships, corporations or foreign shareholders. Eligible business can become an S corporation by submitting form 2553 "Election by a Small Business Corporation" to the Internal Revenue Service. Certain types of businesses are ineligible by the IRS to become an S corporation, including financial institutions, insurance companies and domestic international sales corporations.

Business owners should note, however, that each state has its own guidelines that must be followed in order to file with the IRS as an S corporation.  Recent research from IBM Global Services revealed that the majority – 87 percent – of S corporations have fewer than 10 employees.  [Related: How to Choose the Best Type of Business Entity]

Benefits of an S corporation

The primary benefit of filing as an S corporation with the IRS is that business owners avoid double taxation. By filing as an S corporation, the business isn't taxed by the federal government. Instead, as is done with a limited liability company (LLC) or partnership, shareholders pay individual income taxes on any profits they receive. That profit, however, is taxed at a lower rate than regular income, making it more advantageous to each owner. Should the company experience any losses, each owner can use that to offset any other income on their tax returns. Businesses should check with the state in which they are operating, however, as some do not provide for the tax breaks and instead tax the business as a regular corporation.

Another benefit of using the S corporation structure is that it provides each owner with limited liability protection, which shields owners' personal assets from any company debt or legal matters. Other advantages include being able to easily transfer ownership without unfavorable tax consequences and the fact that shareholders can also be employees who draw a salary from the company.

Drawbacks

There are several drawbacks, however, to using the S corporation structure. One of the most significant is that a larger number of operating rules must be followed, such as holding regularly scheduled director and shareholder meetings, taking minutes at those meetings and constant stock transfer and record maintenance. There are also stipulations that require salaries be paid to each officer and owner, regardless of whether the company is profitable. In addition, the IRS has been known to pay closer attention to the records of S corporations. Anything that doesn't meet the exact requirements for an S corporation could have that privilege revoked, subjecting the business to the regular corporation tax structure.

How to start an S corporation

There are several steps needed to declare a business an S corporation with the IRS, including:

Articles of Incorporation: The first thing a business owner must do is fill out and file the Articles of Incorporation form, also known as a Certificate of Incorporation, with the secretary of state's office. The form spells out the basics of the business, including the name, address, purpose and incorporators.

Filing with the IRS: Once the state has accepted the forms and approved the business' name, IRS form 2553, "Election by a Small Business Corporation," should be obtained and completed. The form, which can be found on the IRS website or at any local IRS office, is the document on which the business can elect to pursue S corporation status. In order for the form to be official, each shareholder must sign the document before it is submitted to the IRS. The form must be filed by March 15 of the tax year during which a business elects to convert to an S corporation. [Related: Tax and Business Forms You'll Need to Start a Small Business]

Determination: Once the IRS receives the form, employees will review it to ensure the business meets all of the eligibility requirements of the S corporation status.

While these are the steps to declare an S corporation, business still must be sure to also collect all the necessary local and state permits when opening for the first time.

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