What is an S Corporation? [Full Breakdown]
You’ve come across a great idea to create a small business and are chomping at the bit to get started. The first step is deciding what type of business entity you want to create. S corporations give you favorable tax benefits and limited liability protection — but what is an S corporation?
S corporations aren’t nearly as common as sole proprietorships, partnerships, and LLCs that we’re used to hearing about, but this type of business may be worth looking into for your venture. However, not all businesses are capable of becoming an S corporation, and for some people, it may be wise to stay away from S corps.
In this guide, we’ll tell you all about S corporations: what they are, the advantages and disadvantages of forming one, and how you can form one. You’ll have everything you need to determine if this type of business is right for you and how you can get started if you think it’s the right fit.
What Is an S Corporation?
S corporations are like a regular C corporation, but shareholders have the advantage of having pass-through taxation. Plus, shareholders have liability protection and aren’t responsible for the business’s debts and legal obligations.
One of the biggest upsides of an S corporation is the ability to have pass-through taxation which prevents double taxation of your income. Double taxation occurs when income is taxed at the business level and then you as a shareholder are taxed separately on your personal income tax return.
Instead, income is passed through to your personal income tax and you end up saving money since you can avoid the pains of double taxation. Each shareholder is then taxed at their own personal tax rate.
S corporations also protect shareholders from personal liability. The business acts as its own entity and shareholders aren’t liable for the debts and legal obligations the business incurs.
This benefits you because you’ll never have to worry about being sued if the business is in some legal hot water. Your personal assets will also be shielded if the business ever falls into debt.
Advantages of S Corporations
For every type of business entity, there are always pros and cons a business owner should consider, and S corporations are no different. Let’s take a look at some of the advantages of forming an S corporation.
As mentioned above, shareholders gain access to some tax benefits, primarily avoiding that pesky double-taxation. S corporations aren’t responsible for taxes on the corporate level. All corporate income is passed through to shareholders’ personal tax returns.
The first few years of starting a business often consist of incurring debts in order to get the business off the ground. Even though the business may be enduring some losses at the beginning, shareholders reap the benefit of passing these losses along to their personal income tax return. They can then write these losses off and reduce the level of their taxable income.
Shareholders are also allowed to receive a salary, dividends, and other distributions, some of which enjoy tax-free status. If done properly, shareholders can reasonably choose how they distribute their income among their personal salary, dividends, other distributions, and business income to achieve a limited tax burden.
Protection from the business’s liabilities, debt, and legal obligations is a huge upside of S corporations. This perk is borrowed from the S corp’s sibling, C corporations.
Sole proprietorships and partnerships don’t enjoy this perk. If things hit the fan, the owners are personally liable for any legal or monetary trouble the business lands in.
The only time an S corporation shareholder would ever be liable for the business is if there was a personal guarantee written up. This would make the shareholder responsible for the same amount as described in the personal guarantee.
Easy Ownership Transfer
There’s really not much to worry about when an S corporation is sold. You won’t need to worry about the adverse tax consequences of transferring ownership. There also isn’t any risk of the business terminating.
With other business entities, like sole proprietorships and partnerships, selling the business can be a headache if it’s even possible at all. There will likely be tax consequences and the potential disbandment of the company.
S corporations require more of a commitment to set up and operate. There are more steps that go into formation, and the term “corporation” just seems to have a nice ring to it. Consequently, other businesses, shareholders, and potential investors may take you more seriously than if you were running a sole proprietorship or partnership.
Disadvantages of S Corporations
S corporations do have some disadvantages you should know about. If you don’t follow the rules and abide by IRS guidelines, you risk receiving tax penalties and potentially losing your status as an S corporation.
The IRS places restrictions on how many shareholders can be part of the business. S corporations can only have 100 shareholders.
Shareholders are required to be legal U.S. citizens, residents, or alien residents. Other businesses like sole proprietorships, partnerships, or corporations are not allowed to be shareholders of the company.
This can be detrimental to the company when searching for more investors. You’re out of luck if you’ve capped out on your number of shareholders. You also can’t accept funds from anyone outside the U.S. or from other businesses that may want to invest in your company.
Costs to Form and Maintain
S corporations fall victim to expenses that sole proprietorships and partnerships don’t need to worry about. To create an S corp, you need to pay filing fees for your articles of incorporation, registered agent fees, and other startup fees. You’ll also need to pay fees throughout the year or on an annual basis. While they may not be that much individually, the fees can add up, and they’re something that sole proprietors and partnerships don’t have to pay.
Perceived Tax Benefits
In some cases, the alluring pass-through tax benefit can be deceptive. While it may seem like you’re going to save money, you may be at risk of receiving more of a tax burden if you’re not careful. You’ll have to pay close attention when filing your taxes at the end of the year.
For example, the pass-through tax benefit may hurt you if it pushes your income into a higher tax bracket on your individual tax return. If you pass-through all your income and it puts you in a tax bracket where you’re paying nearly 40%, then this wouldn’t end up saving you any money at all.
S corporations only have one class of stock. Some investors like to have preferred stock that gives them additional rights, voting power, and dividend reimbursement, but with an S corp, there is only one class. The only distinction an S corporation can make is distributing stocks that have voting power or non-voting power.
If you think an S corporation is the right business entity for you, let’s get you on your way to forming your business entity.
How to Form an S Corporation
Creating an S corporation will require you to first figure out if your business will fit the criteria. You’ll then need to create your business entity and file the IRS form 2553.
1. Determine if Your Business Qualifies
Not all businesses will qualify to be an S corporation. You’ll need to meet the following requirements when you form your business and all throughout the lifespan of the business.
- Domestic company operating within the United States
- No more than 100 shareholders
- Only permit one class of shareholder stock
- Meet the requirements of the specific types of investors
There are also only certain types of businesses that are allowed to become an S corporation. The businesses listed below aren’t allowed to form an S corporation.
- Credit unions
- Insurance companies
- Companies that receive over 95% of gross income from export business
- Companies that take advantage of certain foreign tax credits
If your business endeavor falls within these parameters, then you can move onto the next step and create your business entity.
2. Create Your Business
You’ll now need to incorporate your business. This will require you to file your articles of incorporation, create a DBA, file an EIN, and more. Here are some steps you’ll need to take, much of which we detail in additional articles that can help you out.
- Create a unique business name that’s available in your state.
- File articles of incorporation.
- File a “Doing Business As” name.
- Document corporate bylaws.
- Track meeting minutes to record decisions.
- Apply for an Employer Identification Number (EIN).
- Acquire any permits and licenses you may need.
After that, the only thing left to do is to make it official with the IRS.
3. Complete the IRS Form 2553
To officially obtain S corp status, you’ll need to file Form 2553 with the IRS and indicate that you want to create an S corporation. There are certain time constraints within the federal tax year as to when you can file and additional filing requirements which can be found at the IRS website.
You’ll need to get signatures from every shareholder when filling out this form. After that, you’ll send it to the IRS location in your state. Once your form has been approved — which usually takes no more than 60 days — you’ll be notified of whether or not you’ve been approved.
If everything checks out, then you’re good to go. You now have S corporation status and can reap the tax advantages and personal limited liability protection that this business entity offers.
Is an S Corp Right for You?
So is the S corporation business structure the right one for you? If you fit the bill, you can enjoy the perks of this type of business entity. If not, then keep researching other types of business entities that may make more sense.