When you begin to research how to start a business. One of the first steps is deciding on a structure. S corporations (S Corp) are one of the more common structural choices for corporate businesses in the United States. An S corporation is a closely held corporation that elects to be taxed under Subchapter S of the United States Internal Revenue Code’s Chapter 1—which is where it derives its name. In general, these entities do not pay taxes on corporate income. Profits and losses are passed through to shareholders.
What is an S corp?
An S corporation is a business structure and tax election available to private corporations, like LLCs or partnerships, that is not subject to corporate income tax. In an S corp, profits pass through to the shareholders, who then pay taxes on those profits when filing their personal income taxes.
An S corporation may have no more than 100 principal shareholders or owners, and all owners must be citizens of the US or permanent residents thereof. A properly formed S corporation may not be owned by any other corporate entity, such as another S corporation, a C corporation, a limited liability company (LLC), a partnership, or a sole proprietorship.
Without exception, all S corporations must be governed by appointed boards of directors, who are required to hold annual meetings. They must abide by sets of corporate bylaws, which are strictly regulated by federal and state agencies.
How are S corps taxed?
Generally speaking, S corps don’t pay federal corporate taxes. Instead, the US government exacts those taxes from distributions the corporation pays to shareholders, who report it on their personal tax returns.
In effect, an S corp business structure allows a business to avoid double taxation—being taxed at the corporate level and personal level—which is applied to corporations operating under default C corporation status. This is the primary benefit of becoming an S corp.
Distributions are not subject to employment tax like Social Security and Medicare. But S corps still pay those taxes on all employee wages. Thus, if you’re a shareholder in the company and an employee at the same time (a common thing for small business shareholders), you must pay yourself a “reasonable salary” before paying yourself a distribution. Courts define “reasonableness” in this context as fair compensation for services performed.
The IRS will also look at the big picture when determining salary reasonableness. The agency has warned that if most of the company profits are associated with the employee-shareholder’s personal services, then most of the profit should be allocated as taxable compensation—not as a distribution. For example, if you are the sole shareholder in your S corp, and you make $100,000 in profit prior to any wages paid to yourself, the company’s sole employee, the IRS would likely find it unreasonable for you to take $90,000 of those profits as a non-wage distribution.
Though S corps chiefly concern federal taxation, it’s important to note that they don’t receive consistent across-the-board treatment from state governments. Some states and cities, like New York City, treat S corps entirely like C corps for tax purposes, meaning you will avoid double taxation only at the federal level should you elect S corp status.
What is an S corp election?
Limited liability companies can file an “S election,” which allows them to be taxed as an S corp. These LLCs still operate as LLC business entities, which means they do not have to appoint a board of directors or hold board meetings, but it also means that they cannot issue shares.
How to qualify as an S corp
Not all corporations can become S corps. To successfully elect S corp formation, your business must meet certain requirements set forth by the Internal Revenue Code:
- Your S corp must be a domestic company based and operating in the United States.
- Your S corp’s shareholders must be permitted under the Internal Revenue Code. Your shareholders must be actual people (not partnerships, not other corporations) that are US citizens or permanent residents. You may not have more than 100 shareholders overall.
- Your S corp may only issue a single class of stock. It cannot issue common and preferred stock, like C corps can.
- Your S corp may not be an insurance agency, a bank, or a designated domestic international sales corporation (an export business).
- Your shareholders must unanimously consent to electing S corp status.
How to form an S corp
To elect to form an S corp, you must file a Form 2553—an Election by a Small Business Corporation document—with the IRS. This filing proves that the business has met all of the qualifications expected of a properly operable S corp.
There are two timelines for filing a Form 2553:
- No more than two and a half months (two months, 15 days; 75 days total) after the beginning of the tax year the election is to take effect. For new entities, the tax year begins the date the business starts operations, acquires assets, or issues shares, whichever is earliest.
- After 75 days into the tax year before the tax year in which the S corp is set to take effect. For a company with a fiscal year ending on December 31, Form 2553 must be filed between March 16 and December 31 of a given year, with the election taking effect on January 1 of the new year.
How to operate an S corp
There are a number of essential protocols for properly operating as an S corp. The business must hold regularly scheduled meetings of directors and shareholders. Minutes of those meetings must be recorded in exacting detail. And all of these protocols are formalized in corporate bylaws, which also dictate procedures for maintaining records.
There are certain operating requirements to follow with regard to compensation. Shareholders may receive corporate income in two ways: as salary or dividend distribution. Salaries are subject to payroll taxes and personal income tax; distributions are subject only to personal income tax. Again—if your company is paying too many distributions over salaries, the IRS will notice and possibly issue back taxes against your small business.
Compared with other options for structuring your small business, S corps need more oversight—especially in the realms of accounting and bookkeeping. Because of possible differences in federal and state tax treatment of S corps, you may need regular consultation with a tax attorney.
Pros and cons of S corps
There are a number of advantages and disadvantages to electing to form an S corp, and understanding will help a small business owner make an informed decision with regards to corporate structuring.
Benefits of forming and operating as an S corp
- Tax advantage. The primary benefit of forming an S corp is avoiding double taxation. If you don’t want to pay corporate tax on company earnings, an S corp structure will allow you to pass those obligations onto shareholders and save money.
- Funding: An S corp formed from a traditional corporation can raise money through issuing shares. An LLC, even one that has elected to be taxed as an S corp, may not issue shares to non-members and is thus barred from fundraising in this manner.
- When you sell. Another of the S corp’s tax benefits comes at the tail end of your small business’ story—or, at least, your part in it. Should you decide to sell your S corp, you’ll likely pay much less in taxes than when selling a C corp or other entity. An S corp is a pass-through entity, so you are selling the assets—not the corporation itself.
- Personal liability protection. S corps are legally distinct from their shareholders. This offers shareholders liability protection. In the event the S corp is sued, shareholders’ personal assets cannot be accessed by litigants. Likewise, if the company goes belly up, shareholders’ personal assets are safe from creditors.
Drawbacks of forming and operating as an S corp
There are a number of downsides to acknowledge when considering whether to form an S corp.
- Limitations on shareholders. For corporations—even small business corporations—the ability to issue shares is often a chief means of early stage funding. Because S corps are limited to 100 shareholders, growth in this sense is limited as well. And because corporate growth is often viewed as part and parcel with the size of a shareholder class, potential investors might be put off from investing in an S corp in its early days.
- Heightened scrutiny from federal tax authorities. Because S corp structuring offers certain favorable tax loopholes, the IRS pays extra close attention to S corp companies. The rationale is to discourage S corps from improperly designating certain taxable distributions, like an employee-shareholder’s wages, as distributions that are subject to personal income tax, not employment taxes.
- Time-consuming and costly. Because all the requirements of forming a default C corporation or LLC must be met before electing S corp status, it necessitates significantly more paperwork and energy investment.
S corps vs. C corps: What’s the difference?
S corps are similar to C corps in a few key ways:
- Both are funded through the issuance of stock.
- Both require appointment of corporate officers, e.g., a board of directors.
- Both require boards and shareholders to hold regular meetings and keep detailed meetings thereof.
- Both must draft, file, and abide by company bylaws.
- Both shield shareholders from corporate liability.
- Both C corp and S corp shareholders pay personal-rate taxes on corporate distributions.
They also differ in a few key ways:
- S corps may issue shares to up to 100 shareholders, all of whom must be actual people (not corporations) who are US citizens or permanent residents. C corps face no restrictions in terms of number or type of shareholder.
- S corps may only issue a single class of stock. C corps can issue common and/or preferred stock.
- S corps pay taxes only on employee wages. S corp owners pay personal taxes on distributions and wages. C corps pay taxes on all of the above, as well as corporate income.
S corps vs. LLCs: What’s the difference?
S corps are recognized as their own category by the IRS. LLCs are not—they’re taxed by default, the same way as a sole proprietorship or partnership. But LLCs can elect to be taxed as S corps.
LLCs and S corporations share a number of similarities:
- Both are taxed primarily at the individual level for owners, who are responsible for personal income tax and employment taxes.
- Both can pass profits and losses onto ownership.
- Both shield owners or shareholders from corporate liability.
There are also several stark contrasts:
- LLC owners typically pay self-employment taxes on all income from the business. S corps allow owners to separate their wage earnings (which are subject to employment tax) from distributions (which are not).
- S corps can issue shares to up to 100 shareholders. LLCs don’t issue shares; their owners are referred to as “members,” and they can have an unlimited number of members.
- S corps can only be owned by individuals who are US citizens or permanent residents. The LLC as a business entity is not regulated in this sense.
Final thoughts on S Corps
Electing to form your small business as an S corp can be a time-consuming, effort-intensive, and costly process. It is important for you to understand all the benefits, drawbacks, and implications ahead of time. If you’re considering forming an S corp for your small business, ask yourself:
- Do you envision your company having shareholders? How many?
- Do you have the budget for the operational overhead that comes with an entity type that’s more complex to run and file taxes for than an LLC?
- Can your business afford to pay you a reasonable salary?
- Are you equipped to appoint a board of directors and hold annual board and shareholder meetings?
- Do you envision selling shares of your company to international investors or other business entities?