S corporations are a popular business type. Here's what you should know if you want your business to be one.
- An S corporation is a legal structure that protects business owners from legal issues and financial mishaps with its limited liability.
- One of the biggest benefits of S corporations is that they are pass-through entities and not subject to double taxation.
- To file as an S corporation, you must submit Form 2553 to the IRS.
- This article is for new business owners who are determining whether an S corporation is the best legal structure for their company.
Business owners have several legal structures to choose from when setting up their companies. An S corporation, or S-corp, is one of the most popular options because of the tax benefits and legal protections it provides. S corporations are pass-through entities that aren't subject to double taxation. Additionally, the personal assets of the owners of an S corporation are protected; they can't be seized in any legal matter.
What is an S corporation?
An S corporation, also known as Subchapter S of the first chapter of the Internal Revenue Code, uses a tax structure that gives companies the limited liability of a corporation with the tax advantages of a partnership or LLC.
"An S corporation preserves the limited liability that comes with a C corporation, but is a pass-through entity for tax purposes," Nellie Akalp, CEO and founder of CorpNet.com, told Business News Daily. "This means that, similar to a sole proprietorship or partnership, an S-corp's profits and losses pass through to the owners' personal tax returns. There's no corporate-level taxation for an S-corp."
An S-corp isn't taxed separately from its owners or shareholders. Your corporate profits and losses are reported on shareholders' personal income tax returns, as with a partnership.
Key takeaway: S corporations share the benefits of an LLC in terms of financial and legal protection. An S-corp isn't taxed apart from its shareholders; its profits and losses are recorded on the income tax returns of shareholders.
How do you qualify as an S corporation?
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 be individuals or certain trusts and estates – not partnerships, corporations or foreign shareholders. Eligible businesses can become S-corps by submitting Form 2553, Election by a Small Business Corporation, to the Internal Revenue Service. Ineligible businesses include financial institutions and insurance companies.
Each state has its own guidelines for filing with the IRS as an S corporation. Recent research from IBM Global Business Services revealed that the majority (87%) of S corporations have fewer than 10 employees. [Read related article: How to Choose the Best Legal Structure for Your Business]
Key takeaway: S-corps can't have more than 100 shareholders, must file Form 2553 with the IRS, and cannot be a financial institution, insurance company or sales corporation. Shareholders must be U.S. citizens.
What are the benefits of an S corporation?
One reason an S-corp is such a popular entity among small business owners is that it allows you to save money by avoiding corporation taxation and protects its shareholders through legal safeguards.
The primary benefit of filing as an S corporation with the IRS is that you avoid double taxation, as this is considered a pass-through entity. A business that files as an S-corp isn't taxed by the federal government. Instead, as with a limited liability company (LLC) or partnership, shareholders pay individual income taxes on any profits they receive that have "passed through" the business.
That profit is taxed at a lower rate than regular income, making it more advantageous to each owner. Should the company experience losses, each owner can use that to offset any other income on their tax returns. You should check with the state where your business operates, however, as some do not provide for the tax breaks and instead tax the business as a regular corporation.
Another benefit of the S-corp structure is that it provides each owner the protection of limited liability, which shields owners' personal assets from any company debt or legal matters. If your business is sued, money in your personal bank accounts can't be taken in any court-ruled judgments.
Ease of conversion
Another advantage is that you can easily transfer ownership without unfavorable tax consequences.
Salary and dividend payments
Shareholders can also be employees who draw a salary from the company. Akalp said S-corp owners can receive both a salary and dividend payments from the corporation.
"This can result in a lower tax bill overall," she said. "Why? This is because dividends are not subject to self-employment tax. Further, the S corporation can deduct the cost of the wages paid when computing the amount of income that is passed through to the shareholders."
The IRS determines the division between salary and dividends.
Key takeaway: Filing as an S-corp gives your business liability protections, lower tax rates, and the ability to transfer ownership without facing harsh tax penalties. Additionally, owners can receive both salary and dividend payments from their business.
What is the difference between an S corporation and C corporation?
The difference between an S corporation and a C corporation is how the business and shareholders are taxed and the number of shareholders necessary to qualify.
S-corps don't pay income tax or face double taxation. The shareholders can take income from the company without facing any additional taxation. An S-corp is taxed as a pass-through entity, which means it's not taxed separately from its owners. It cannot have more than 100 shareholders.
"Each shareholder must be an individual or a trust (not another corporation)," Akalp said. "And each individual shareholder must be a citizen of the United States or a 'resident alien,' which includes permanent residents."
A C-corp, on the other hand, must pay tax on its income. Additionally, its shareholders must pay tax on dividends from the corporation, which means they face double taxation of income.
Key takeaway: Unlike C corporations, S-corps do not pay taxes on their income, as they are pass-through entities.
How do you start an S corporation?
You need to take a couple steps to declare your business an S corporation with the IRS:
- File your articles of incorporation. The first thing you must do is fill out and file the form for articles of incorporation, also known as a certificate of incorporation, with your secretary of state's office. The form spells out the basics of your business, including its name, address, purpose and incorporators.
- File as an S-corp with the IRS. Once your state has accepted the forms and approved your business's name, you need to complete and file Form 2553, Election by a Small Business Corporation. The form, which you can find on the IRS website or at any local IRS office, is the document that you use to pursue S-corp status. For the form to be official, each shareholder must sign it before you submit it to the IRS. You must file the form by March 15 of the tax year during which your business elects to convert to an S corporation. The IRS will review your form to ensure your business meets all of the eligibility requirements for S-corp status.
While these are the steps to declare your business as an S corporation, you must also collect all the necessary local and state permits for opening a business. Keep in mind that you must be operating in the United States, have no more than 100 shareholders and issue just one class of stock when you start an S-corp. [Read related article: Tax and Business Forms You'll Need to Start a Small Business]
Key takeaway: To start your S-corp, fill out the articles of incorporation form with all your company's information and file Form 2553 through the IRS. To be eligible, your company must be based in the U.S. and have no more than 100 shareholders and one class of stock.
What are the drawbacks of an S corporation?
One significant drawback of the S corporation structure is the larger number of operating rules you must follow, such as holding regularly scheduled director and shareholder meetings, taking minutes at those meetings, and performing constant stock transfer and record maintenance. Some stipulations require salaries for each officer and owner, whether the company is profitable or not.
In addition, the IRS has been known to pay closer attention to the records of S corporations. Any company that doesn't meet the exact requirements for S-corp status could have that privilege revoked, subjecting the business to the regular corporation tax structure.
Key takeaway: Compared to other business entities, S corporations are under critical watch by the IRS. There are also several rules for compliance, like having frequent shareholder meetings.
Chad Brooks contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.