Electing to form an S corporation over other business entity types when starting a business can make a major difference in how much a business ends up paying in taxes and how profits and dividends are ultimately managed.
What is an S corporation?
An S corporation is a business structure and tax election available to private corporations, like limited liability companies (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 US citizens or permanent residents. An LLC may also elect to be taxed as an S corporation.
Without exception, all S corporations must be governed by appointed boards of directors who are required to hold annual meetings. They are to abide by sets of corporate bylaws, which are strictly regulated by federal and state agencies.
What is required to form an S corporation?
Should you choose to form your enterprise as an S corporation, such a venture must meet certain requirements set by the United States Internal Revenue Service. Requirements include:
- Selecting a business name. Your S corporation must have a unique name that does not infringe on any existing registered trademarks.
- Appointing a board of directors. The IRS requires that all S corporations be governed by a board of directors.
- Holding annual board meetings. The IRS also requires that all S corporation boards hold regularly scheduled meetings at least once a year and keep detailed minutes of those meetings.
- Filing articles of incorporation. S corporation articles of incorporation must be filed with the IRS and the secretary of state in the state where the S corporation is to be formed.
- Writing and filing bylaws. The IRS requires that all S corporations abide by internally drafted and enforced corporate bylaws. Such rules outline the process for appointing and removing board directors, issuing stock, scheduling meetings, conducting board votes, and replacing directors in the event of a death on the board.
- Issuing stock. Once bylaws with regards to stock issuance have been established, an S corporation may issue stock to shareholders. These can be in the form of common stock, which comes with shareholder voting rights, or preferred stock, which comes with priority payment of dividends, but no voting rights.
- Filing tax forms. The owners of an S corporation must first file Form 2553—an Election by a Small Business Corporation document. This filing proves that the business has met all requirements of the IRS to operate as an S corporation. You can file Form 2553 in one of two contexts:
- No more than two and a half months (two months, 15 days; or 75 days total) after the beginning of the tax year the election to S corporation status is to take effect. For new entities, the tax year begins the date it commences business operations, acquires assets, or issues shares, whichever happens first.
- After 75 days into the tax year before the tax year in which the S corporation is set to take effect. For a company with a fiscal year ending on December 31, the S corporation election 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.
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Once the above requirements are fulfilled, your S corporation has been properly formed in accordance with IRS regulations.
Pros and cons of S corporations
A decision to form as an S corporation, and subsequently be taxed as an S corporation, will lie chiefly in whether your company’s interests align with the below advantages without being excessively burdened by the below drawbacks.
Advantages of forming and operating as an S corporation
S corporations provide a number of advantages to owners and shareholders, primarily with regards to liability shielding and optimizing tax benefits.
- Protection from liability. S corporations are legal entities entirely distinct from the corporation’s shareholders—shareholders are therefore protected from liability directed at the company. If the company is sued, plaintiffs cannot access the personal assets of shareholders, should they succeed.
- Avoids double taxation. An S corporation is a pass-through entity, meaning corporate profits and losses “pass through” to ownership. As a result, business income is not subject to corporate tax, something C corporations don’t benefit from. C corporations are subject to so-called “double taxation”—corporate earnings are taxed along with personal earnings of owners and shareholders.
- Savings on self-employment taxes. S corporation shareholders do not pay self-employment taxes on distributions from business profits. They are taxed on any salary they pay themselves, however, and before recognizing any profits, the S corporation must pay reasonable compensation to any owner who also works as an employee. This salary is subject to certain payroll taxes (e.g., Social Security and Medicare taxes), which are paid half by the employee and half by the S corporation. Any savings accrued from paying no self-employment tax on profits, therefore, are activated only once the S corporation is earning enough to sustain profits after paying out salaries.
Disadvantages of forming and operating as an S corporation
There are a number of disadvantages to forming and operating as an S corporation, including some of the strictest restrictions on ownership and shareholding. Drawbacks of opting for this entity structure include:
- Shares are recognized as forfeitable assets in court—they may be seized or compelled into sale in legal proceedings.
- Limitations on scope and profile of shareholding—a maximum of 100 shareholders, all of whom must be US citizens or resident aliens. These shares must be held directly by the shareholders.
- Owners or employees who hold more than 2% of the S corporation’s shares may not receive corporate health benefits as a tax-free distribution.
- Pass-through taxes are paid at shareholders’ personal tax rate. High-income shareholders pay more taxes on dividends and distributions.
- If an S corporation’s tax status is compromised by the existence of a non-resident shareholder or stock being owned by another corporate entity, the IRS will revoke the status, charge back taxes for the previous three years, and impose a five-year waiting period to regain S corporation status.
How do S corps compare to other entity types?
S corporations share a number of similarities with other common business structures, such as LLCs and sole proprietorships. However, they also differ in a few key ways.
S corporations vs. sole proprietorships
Sole proprietorships are a type of unincorporated business where one person is the sole owner, responsible for running the entire business.
Unlike in an S corporation context, there is no legal separation between an owner (or sole proprietor) of a sole proprietorship and the business itself. The owner of a sole proprietorship is therefore not protected from any liability suffered by the company. If the sole proprietorship is sued or in debt, litigants or creditors may reach an owner’s personal assets. S corporations provide owners and shareholders with liability protection by separating the assets of the company from their assets.
S corporations vs. LLCs
A limited liability company is a business structure that protects owners from personal responsibility for a corporation’s debts or legal liabilities. An LLC essentially melds aspects of a corporation with characteristics of a sole proprietorship. S corporations and LLCs are similar in some ways, different in others.
How they’re similar:
- S corporations and LLCs both offer liability shields to owners and shareholders—both business entities are legally separate from the personal assets of owners and shareholders. Should either an S corporation or LLC be sued, or fall into debt, the personal assets of these groups would be protected from litigants or creditors.
- S corporations and LLCs are also both pass-through entities—neither form of business pays taxes on corporate income, but both require that owners and shareholders report earnings and losses on personal tax returns.
How they’re different:
- LLCs are a lot easier to establish and less expensive to operate than S corps.
- LLCs are not subject to the same strict IRS rules and are not required to maintain boards of directors or bylaws, or to conduct annual meetings.
- An LLC is also a more flexible entity form, allowing owners to retain more control over operations.
- S corporations have resources at their disposal to incentivize outside fundraising—such as issuing stock.
While an LLC can be dissolved if a member or owner withdraws from the organization, an S corporation tends to live on in perpetuity.
Plenty of small business owners opt to run their enterprise as an S corporation. It’s a structure that carries a number of tax advantages, including many found in LLCs and other partnerships, while offering the liability shield of a more traditional C corporation. Think of it as a middle ground between the two subcategories of legal entities.
Though ideal for leaner, fast-growing startups, restrictions on the size of the shareholding class may be a roadblock to future expansion. It is crucial for you to factor in the long-term vision for your small business when weighing whether the S corporation is the right business entity structure for you.