Starting a business involves making many important decisions. One of the first steps is choosing the right business structure. S corporations, or S corps, are popular for small and medium-sized businesses in the United States. But what exactly is a S corp, and how does it work?
In this comprehensive guide, we’ll explain everything you need to know about S corps, including:
- What is a S corporation?
- S corp benefits and drawbacks
- S corp requirements
- How to form a S corporation
What is a S Corporation?
A S corporation, or S corp, is a legal business structure that combines the limited liability of a corporation with the tax benefits of a partnership or sole proprietorship.
Here’s a quick overview:
- S corps are incorporated at the state level, like C corporations. It gives S corps limited liability protection.
- But for federal income tax purposes, S corps can “pass-through” income to shareholders. It avoids the “double taxation” issue faced by the C corps.
- S corps have strict eligibility requirements related to the number of shareholders, shareholder types, classes of stock, etc.
- S corps require more administration than sole proprietorships or partnerships but less than C corps.
So, in essence, S corporations give small businesses the liability protection of a corporation with the tax flexibility of a partnership. This unique combo makes S corps popular for many small business owners.
Now, let’s look at the benefits and drawbacks of S corps in more detail.
S Corporation Benefits
Pass-through taxation – It is the #1 reason most small businesses choose the S corp structure. S corps avoid double taxation by passing income directly to shareholders to report on their personal returns. It saves a ton on taxes compared to the C Corps.
Limited liability – S corps protects owners from business debts and liabilities as a separately incorporated entity. Creditors can’t go after your assets like they could in a sole proprietorship or partnership.
Flexible shareholder compensation – S corps gives owners flexibility in paying themselves. You can take distributions, wages, or both, providing tax optimization opportunities.
Raising capital – S corps can issue stock to bring on investors and raise capital. It isn’t as easy with LLCs or partnerships.
Business credibility – Being incorporated gives your business more credibility in the eyes of customers, partners, and lenders. The corporate structure projects stability.
No special tax forms – S corps use the same Form 1120S tax return as other corporations. You don’t need to file special partnership returns like with LLCs.
Easy conversion – Existing LLCs and C corps can easily convert to S corp status by filing Form 2553 with the IRS. No need to dissolve and re-form the business.
S Corporation Drawbacks
Strict eligibility requirements – S corps has a long list of formation and operational requirements related to ownership structure, stock classes, subsidiary businesses, etc.
Added administration – S corps requires corporate formalities like adopting bylaws, holding director/shareholder meetings, filing annual reports, and keeping minutes. This administrative burden is higher than with LLCs.
Self-employment taxes – S corp income is subject to full self-employment taxes, unlike LLCs where you can take a reasonable salary. It can mean higher taxes for some owners.
One class of stock – All S corp shareholders must hold the same class of stock with equal rights. Preferences or special allocations among shareholders are prohibited.
Shareholder restrictions – S corps can only have up to 100 shareholders, and all must be US citizens or residents. It makes S corps inaccessible to many investors.
Limited fringe benefits – Only 2% of S corp shareholders can take advantage of fringe benefits like health insurance premium deductions.
Termination risk – Violating one of the many S corp requirements can lead to involuntary termination of S corp status and a transition back to C corp taxation.
As you can see, S corps offers some great perks but also has limitations and drawbacks. Make sure you weigh both sides before choosing the S-corp structure.
S Corporation Requirements
To qualify for S corp status, a business must meet specific IRS requirements related to formation, ownership structure, stock classes, etc. Here are the key S corp eligibility rules:
Must be a domestic corporation formed in the United States
- Have 100 or fewer shareholders
- Have only eligible shareholders who are individuals, estates, exempt organizations, or certain trusts
- Have only one class of stock issued
- Cannot have nonresident alien shareholders
- It cannot be an insurance company or a certain financial institution
In addition, S corps must follow certain operational requirements to maintain their special tax status:
- Shareholders must be paid reasonable compensation for services rendered.
- Must file Form 1120S to report shareholder income, deductions, losses, etc.
- Must file Form 2553 to elect S corp status
- Cannot own 80% or more of a C corporation subsidiary
Violating any of the S corp eligibility rules can lead to involuntary termination by the IRS and a switch back to standard C corp taxation. So it’s critical to stay compliant if you want those sweet S corp tax benefits!
How to Form a S Corporation in 11 Steps
Follow these key steps to establish your business as a S corporation properly:
Choose a Business Name
- Research availability and register your chosen name with the state
- Include a corporate designation like “Inc.” or “Corp.”
Appoint Directors and Officers
- Appoint initial board members to oversee high-level policies
- Elect officers like the President, Secretary, and Treasurer to manage daily operations.
File Articles of Incorporation
- Draft articles establishing your corporation as a legal entity
- File articles with your Secretary of State’s office
Create Corporate Bylaws
- Outline operating rules like shareholder meetings, voting, etc.
- Formally adopt bylaws at the first board meeting.
Issue Stock
- Document stock distribution to initial shareholders
- Outline classes of stock, voting rights, dividends, etc.
Hold Organizational Meeting
- Elect directors, approve bylaws, authorize stock issuance
- Document meeting minutes showing formal corporate actions
Obtain EIN from the IRS
- Acquire federal EIN to open bank accounts, pay taxes
- Apply online via the IRS website
File S Corp Election with IRS (Form 2553)
- Submit within two months and 15 days of the intended S corp status date.
- All shareholders must consent to the S corp election.
Follow State Formalities
- Register to do business in states where operating
- File annual reports to maintain incorporation
Issue Stock Certificates
- Formal certificates documenting percentage ownership
- Signed by an authorized officer like the President or Secretary
Maintain Corporate Records
- Keep minutes, bylaws, and stock ledgers to document actions
- Store records at the registered office
These key steps will ensure you establish and maintain your S corporation status properly. Let me know if you need any clarification or have additional questions!
Frequently Asked Questions:
What are the main advantages of an S corp?
The two biggest advantages of an S corp are:
– Pass-through taxation – S corp income passes through to shareholders to avoid double taxation.
– Limited liability protection – S corps limits owners’ personal liability like a corporation.
What are the eligibility requirements for forming an S corp?
To form an S corp, a business must:
– Have 100 or fewer shareholders
– Have only eligible shareholders (individuals, certain trusts/estates)
– Have only one class of stock
– Be a domestic corporation
– Not be excluded like certain financial institutions
The Bottom Line on S Corps
S corporations offer a compelling middle ground between sole proprietorships’ simplicity and full C corporations’ liability protection. The pass-through taxation of S corps also provides significant tax savings for many small business owners.
However, the eligibility requirements, ownership restrictions, and administrative formalities make S corps more complex than LLCs. You’ll need to weigh whether the S corp structure is worth the trade-off for your specific business situation.
Key factors to consider include:
Your projected income level and tax bracket
- Desired liability protection
- Need to raise outside investment
- Number of owners involved
- State tax treatment of S corps vs. LLCs
Consult with legal, tax, and financial advisors to determine if S corp status makes sense for your business. Carefully evaluate both the advantages and disadvantages before incorporating.
With the right preparation and planning, an S corp can provide an optimal structure for launching and growing a successful small business. Take the time to make an informed decision before filing those S corp election forms.
I hope this comprehensive guide has provided clarity on what S corps are all about. Let me know if you have any other questions!
