An S corporation is a closely held corporation that elects to be taxed under Subchapter S of the US Internal Revenue Code’s Chapter 1—which is where it derives its name. In general, these entities don’t pay taxes on corporate income. Profits and losses are passed through to shareholders.
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What is an S corp?
An S corporation is a business structure and tax election available to private corporations, like LLCs or partnerships, that isn’t 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 United States 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 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 Service (IRS). Additionally, the business must meet certain filing requirements with the IRS and state tax authorities.
Requirements for S corps generally include:
- 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 IRS. Your shareholders must be actual people (not partnerships, not other corporations).
- 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.
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’s 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’re 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 can’t 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.
Alternatives to S corps
The S corp structure is similar to other corporate entities in that the owners have limited liability and aren’t personally responsible for the company’s debts or liabilities.
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?
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.
Is an S corp right for your biz?
Electing to form your small business as an S corp can be a time-consuming, effort-intensive, and costly process. It’s important 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?