An S Corporation, or S corp for short, is an electable tax designation available to corporations and limited liability companies (LLCs). This status is a popular choice amongst business owners because of the advantages it offers, including personal asset protection and tax benefits. It exempts them from paying corporate income taxes.
The structure of an S corp depends on whether or not your business is formed as a standard S corporation or an LLC. S corps provide the liability protection of a corporation with the flow-through taxation of a partnership. This aspect is similar to limited liability companies and some forms of limited partnerships. But because S corps are subject to heavy compliances, limited liability companies may be a better choice for small businesses.
So let’s check what exactly is an S corporation? What are the advantages of becoming one? And how do you become one?
What is an S corporation
“S corporation” means “Subchapter S corporation”, and is sometimes “Small Business Corporation.” It’s a tax status specially granted by the IRS to enable corporations to pass their corporate income, credits, and deductions through to their shareholders.
Generally speaking, S corporations are not charged income taxes. Instead, the individual shareholders of the company have to pay the taxes on revenue after being distributed and report it in their personal income tax returns.
An S corp is not taxed separately from its owners. S corps are different from C corporations, which are subject to double taxation. S corporation status lets businesses avoid double taxation, which is how it would be charged otherwise. First, the business is taxed (corporate tax), and then the income of the business owner is taxed. In the absence of corporate tax, the S corp “tax rate” is according to the business owner’s personal income tax level bracket.
Remember, that “S corporation” is a tax designation, not a type of business structure. You don’t get registered as an S corp. Company Formation under the law will automatically classify it as a C corporation for Federal tax purposes. To be designated as one, you have to apply to the IRS. To become an S corp, the shareholders must elect to be taxed under the Subchapter S of the Internal Revenue Code (IRC). The election is made by filing Form 2553 (Election by a Small Business Corporation).
S corps are required to report their income to the IRS on Form 1120S.
Important Note: If the corporation had earlier operated as a C corp, the results of converting to subchapter S status (including the built-in gains tax) must be weighed properly.
How to become S Corporation
1. Become a Corporation (or an LLC)
Before you can apply for S corp status, you must complete the process as a regular Company formation, which is just another C corp.
To be incorporated as a corporation, you need to approach the State For more on C corporations and what articles of incorporation you’ll need to become one, check out this guide.
Alternatively, you can elect S corp tax filing status if you’re an LLC and you fulfil the IRS’ criteria for S corp status.
To form a corporation:
- Conduct Business Name Search for a unique name and reserve it with the Secretary of State.
- Draft and file Articles of your Incorporation with the Secretary of State.
- Issue stock certificates to the shareholders/members.
- Apply for a business license and other certificates as per your industry.
- File Form SS-4 or apply online at the IRS website to obtain an Employer Identification Number (EIN).
- Apply for any other ID numbers required by your State and local government authorities. Requirements vary from one jurisdiction to another, but generally a business is required to pay unemployment, disability, and other payroll taxes – so you will need tax ID numbers for those accounts other than your EIN.
- File the IRS form 2553 within 75 days of the company formation.
2. Qualify for S corporation Criteria
Not all corporations get designated S corp status by the IRS. To apply for this status, your company must first satisfy the below conditions:
- Must be a domestic corporation—that is, formed and operating in the US.
- Can only have “allowable” or resident shareholders—this means that none of them can be partnerships, other corporations, or non-U.S. citizens.
- Cannot have more than 100 shareholders.
- The class of stock is only single—for example, it can’t have a two-tiered common and preferred stock system.
- Is not an insurance company, bank or a domestic international sales corporation.
- All the company’s shareholders must unanimously elect to S corporation status.
3. Filing Form 2553
Once all of the IRS’s requirements are being surely fulfilled, you are to then submit Form 2553, Election by a Small Business Corporation, signed by all the company’s shareholders.
2553 is a four-part tax form:
Part I: Election Information
In this part, you’ll need to fill in the basic information about your company, including:
- The name, address, date of incorporation, state of incorporation and EIN for your business
- Name and contact details for a corporate officer who the IRS can contact about your application
- Information about the tax year for which your company want to hold S corporation status
On page two of Part I, you are to attach the name, address, signature, the number of shares (or percentage of ownership) and social security number (SSN) of each of the shareholders.
Part II: Selection of Fiscal Tax Year
This part will ask a few questions about the business’s tax year.
Part III: Qualified Subchapter S Trust (QSST) Election u/s 1361(d)(2)
This section applies only to trusts applying for S corp designation. You are to fill in the income beneficiary’s name, address, and SSN, the trust’s name & address, and its EIN.
Part IV: Late Corporate Classification Election Representations
This part only concerns to companies that are filing their application for S corporation after the IRS deadline.
To qualify for S corp status in the same year that you’re applying for it, you must file Form 2553 “no more than 2-months and 15-days after the beginning of the tax year the election is to take effect.”
So if you incorporated your business on January 1st, 2020 and would like to be taxed as an S corp in this year, you must have submitted 2553 by March 15, 2020.
Advantages of becoming an S corporation
Save on taxes: The primary benefit of becoming an S corp is avoiding double taxation. Some business owners prefer not to pay a corporation tax, and then being taxed again on their individual tax returns. But to assess whether the S corp status is in your and your business’s best interest, you must approach a professional tax expert.
S corporations only need to pay employment tax (Social Security and Medicare) on employee wages. The rest of the revenue is allocated to the shareholders in the form of “distributions” that are not subject to self-employment tax. This pass-through entity feature is what makes S corporation status very attractive to many small businesses.
The only hiccup is if you’re a shareholder, as well as an employee, of the company, which most small business owners are, you must pay yourself a “reasonable wage” before giving yourself a tax-free distribution.
So, what exactly is a reasonable salary? There is no hard and fast rule by the IRS for this one. It would be based on the position, experience, business size and what a comparable position the business is at than another company in your industry.
The shareholder/employee of the S corporation will try to minimize their salary so that the size of their tax-free distribution gets maximized. Whatever salary you decide on, be sure you can justify it with the IRS in case it decides to audit you.
Reduced tax imposed if you sell: If you ever need to sell your S corp, you’ll be required to pay a lot less in taxes selling the business than you will be selling a C corp. (In a partnership or an LLC, the transfer of more than a 50% interest or holding can trigger the termination of the entity). The S corp does not need to or comply with complex accounting regulations when the interest is transferred or adjust to the property basis.
Personal Liability Protection: Shareholders receive protection from being personally liable for the business. So your personal assets can’t be taken to settle business-related debts. This means that if the S corp is sued, your personal assets are insulated from those lawsuits. In a sole proprietorship or general partnership firms, legally, the owners and the business are same—leaving personal assets vulnerable.
Tax-favorable characterization of income: S corporation shareholders can become employees of the business and draw salaries. They can also receive dividends from it, along with other distributions that are tax-free to the extent of their investment in the corporation. A reasonable characterization of arrangements as salary or dividends can help you reduce tax liability, while still generating business-expense and wages-paid deductions for the corporation.
Cash method of accounting: Corporations must use the accrual method in accounts unless they are small corporations. (A small corporation has gross receipts of $5,000,000 or less.) S corp, however, usually don’t have to use this accrual method unless they have inventory.
Better credibility: S Corp Registration may help a business establish credibility with potential customers, vendors, employees, and partners because there is a formal commitment to the business by the owner.
Disadvantages of S corporation status
Strict requirements: If your business fails to meet any of the IRS’s conditions for S corp at any point, the status can be revoked immediately and your business will get taxed as a C corp instead. This would create huge difficulties around tax deadlines.
If you expect there is some chance of your company violating any of the IRS’s requirements—for example, if your fast-growing business has expanded its shareholder base beyond the 100 allowed shareholders—S corporation status might not be for you.
Closer tax scrutiny: The IRS keeps a close eye on whether the “reasonable” salaries, that corporate officers are paying themselves, are indeed reasonable. If it is suspected that a shareholder has misreported wages to lower their tax burden, they may recategorize additional corporate earnings as wages, thereby causing a significant increase in the shareholder’s tax payment. Although this is almost rare, and usually can be corrected smoothly, it is still a subject that is not a factor with other business types.
Stock ownership restrictions: An S corp can have only one class of stock, even though it can have both voting and non-voting shares. There can’t be different classes of investors being provided with different dividends or distribution rights. Also, the number of members is limited – it cannot be more than 100 shareholders. Foreign ownership is completed forbidden, so a non-resident cannot be an owner. Also, cannot be owned by certain types of trusts and other entities.
Double Check with your state
While lower taxes and other advantages make the S corp an attractive status to have, however, these aren’t treated equally by each State. For instance, in some States S corps are treated the same as C corps for State tax purposes. This implies that you’ll be able to reap the benefits only at the federal level. Consult with a tax expert to make sure you’re aware of your State’s rules concerning S corp.
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