When deciding what structure to use for your business, corporations are one of the most well-known forms. A corporation comes with extra protection, but also has some drawbacks, particularly related to the way they are taxed. Many businesses choose to elect S corp status with the Internal Revenue Service and follow the Internal Revenue Code guidelines. Why? With an S corp status, you may be able to turn your business into a pass-through entity and avoid some tax penalties while still gaining protection from liability.
What is an S Corp?
An S corporation refers to Subchapter S of the first chapter of the Internal Revenue Code. While it is often thought of as a business entity structure, an S corp is actually a tax election that gives a company the liability protection of a corporation while still offering the tax advantages of a partnership or LLC.
In a traditional corporation, businesses are subject to something known as double taxation, in which the corporate income is taxed AND shareholders pay income taxes on their own profit. An S corp has a different taxation process similar to a sole proprietorship or partnership, where all profits and losses pass through to the owners’ personal tax returns. This means there is no corporate-level taxation in an S corporation. No separate taxes are filed for the business.
Importantly, an S corp maintains the same level of personal liability protection as other corporations. Financial and legal obligations in the name of the business are not applied to the owners of the business.
Who should start an S Corp?
S corp taxation status is available to businesses that have already been formed as an LLC or a corporation. Businesses that are already formed and already have a federal tax ID number can apply for this status. However, there are eligibility requirements that must be met.
An S corporation must be a domestic company that has no more than 100 shareholders and issues only one class of stock. The shareholders for these businesses can only be individuals or certain types of trusts and estates and cannot be corporations, partnerships, or foreign shareholders. Financial institutions and insurance companies are also ineligible for this election.
Steps to electing S Corp status
The exact steps for electing an S corp status will vary based on the type of business you own and your location. Below are the general steps, though you may find some differences in your own scenario.
1. Form your LLC or C corp
You will need to follow all the relevant steps to form a business without S corp status. This will include choosing a name, filing Articles of Incorporation with the secretary of state, paying any applicable fees, and following all regulations. You may need to name a registered agent, draft articles of organization or incorporation, create bylaws, and name corporate officers and members.
2. Obtain a federal tax ID number
As a part of starting a business, you will need to request a Federal Employer ID Number, also known as an FEIN, EIN, or Tax ID. This will be a nine-digit number that the IRS uses to track your taxes and refer to your business, in the same way, a Social Security Number is used for an individual.
Once your business is officially formed, you can visit the IRS website to apply online and be issued an EIN immediately. You can also send the application via fax or mail.
3. Ensure you meet all requirements
Before you apply for S corp status, you should be sure that your LLC or corporation meets all requirements. This means you cannot have issued more than one type of stock and the number of shareholders must be 100 or less. These shareholders can be individuals or certain trusts and estates, and they cannot be non-resident aliens, corporations, or partnerships.
Your business also cannot be an ineligible corporation, such as an insurance company, financial institution, or domestic international sales corporation.
4. File S-corp election paperwork
If you meet the IRS requirements, you can complete Form 2553, Election by a Small Business Corporation through the IRS.
In order for your S corp status to apply to the current tax year, you must meet the filing requirements and complete the process within two months and 15 days from the beginning of that tax year. If your election falls after this, it will become valid in the following tax year.
5. Maintain requirements
Like any corporation, an S corp must maintain all annual requirements, such as recording notes at annual meetings and filing an annual report. In addition, they must continue to meet the criteria for an S corp. While you do not have to reapply for the S corp election, falling outside of the criteria means LLC owners must return to a C corp or LLC taxation structure. Failing to report this change can result in tax or even legal consequences.
Advantages of S Corps
S corps are ideal for tax purposes, but business owners like the s corporation status for several reasons, including:
The primary benefit of an S corp structure is that it circumvents the double taxation that other corporations are subject to. As a pass-through entity, an S corp is not taxed by the federal government. Instead, shareholders file an income tax return and pay taxes on any profit and loss they receive after it has “passed through” the business.
This profit is taxed at a lower rate than other income, making it the better choice for individual owners. In the event that the business suffers a loss, the owner can use this to offset their other business income on a tax return. State laws around income taxes may vary, but federal tax protection is the main reason someone may elect an S corp.
Each owner of an S corp is afforded the highest level of liability protection of any business structure, like that of any corporation. Owners’ personal assets are shielded from any company debt or legal matters. If the company is sued, goes bankrupt, or owes any debts, the individual owners cannot be held liable as they could in something like a sole proprietorship.
Transferring ownership of a business can lead to tax consequences in many cases. S corps do not penalize anyone involved in these transactions.
Salary and dividend payments
In many cases, a shareholder may also be an employee who draws a salary from the company. Taking both a salary and a dividend payment can lead to a lower tax bill, as the dividend is not subject to self-employment taxes. The S corp can then deduct the cost of the salary paid when computing its passed-through income.
Disadvantages of S Corps
Regulations and guidelines
In order to qualify as an S corp, businesses must meet set criteria. In addition to this, they must maintain a set of requirements going forward. This includes holding annual meetings and recording minutes, nominating a board of directors, and recording shareholder activity. These administrative regulations can be a lot of work for smaller companies and may also lead to annual fees that are higher than other structures.
The IRS has also been known to pay closer attention to the records of S corporations to ensure they meet all guidelines exactly.
Varies by state
While an S corp is a structure with the federal tax authorities at the IRS, some states do not allow the same structure to be used on income taxes. In these states, all state taxes will be applied as they are to C corporations. This may make taxes more complicated and cause them to be higher at the state level.
An LLC, or Limited Liability Company, is a legal entity that which businesses can be formed. LLCs can choose to use the tax structure of an S corp, which refers to the way their profit and loss are taxed. While an LLC can become an S corp if they meet certain criteria, not all LLCs are S corps. S corps can also be created when the original business was a C corp and not an LLC.
In order to become an S corp, a business must meet certain requirements. These include having no more than 100 shareholders, all of whom must be private individuals or trusts/estates and not nonresident aliens. The business can also only issue one class of stock, meaning members must all have the same distribution amount. Entrepreneurs failing to meet all four of these criteria means a business is no longer eligible for an S corp election.
S corp is a designation from the IRS, which manages federal taxation. However, most states in the US allow for S corp status to be used on state-level taxes as well without a separate election. Some states, like New York, require a separate election; other states do not allow pass-through taxation at all and will require corporate taxation.
Yes. Any requirements a state has for opening a corporation, like a registered agent, will be applied to an S corp. The business must be formed according to these requirements before the S corp application can be completed. You can be your own registered agent or appoint someone else, but you must have one until the company is dissolved or moved to another state.
S corp election means a business does not have to pay taxes related to income, losses, deductions, and credits from the business. However, the corporation can be liable for tax on certain passive income and built-in gains. They will also have to pay non-income taxes, like employment taxes, at the federal level. Some states may have additional tax benefits and requirements as well.
Before becoming an S corp, you must form your business through your state. This process varies in timeline depending on if you are forming an LLC or corporation and each state’s requirements. Once you have formed your business and filed your S corp application, a determination should be made within 60 days. This may be delayed if there are further questions from the IRS or if they need to research more.
If your election is filed within two months and 15 days from the beginning of a tax year, you will be able to apply your S corp election to that year’s taxes. Filing after this date will mean you cannot pass through the taxation until the following year. The election must also take place within 75 days of the date of formation of the business.
S corps do not have a tax rate. Owners of these businesses pay personal income tax based on the company’s net profits, with the income tax rate depending on their income bracket. Other tax rates, like unemployment and payroll rates, may also apply.
The S corp election form does not have an associated application fee. However, you will have to pay any filing fees within your state to form an LLC or corporation, as well as annual fees to maintain your business’ status. This cost will vary by state.