An S corporation (S corp) is a type of pass-through entity that allows small businesses to avoid double taxation while also providing limited liability protection to shareholders. Though this entity can be a great option for some small businesses, the specific legal and administrative requirements for S corps may not be right for all business owners.
Starting a small business can be an exciting and challenging endeavor. As a small business owner, you want to ensure that you have the legal protection and financial benefits necessary to succeed in today’s competitive market. One option to consider is forming an S corporation. But how is an S corp different from other entities?
Today, we’ll explore what S corporations are, the advantages and drawbacks of forming an S corp, and what you need to know before forming one.
What is an S corp?
An S corporation, also known as an S subchapter corporation or S corp, is a type of business structure that allows a corporation to avoid paying federal income tax at the corporate level. Instead, the profits and losses of the business pass through to the shareholders, who report them on their personal tax returns.
S corps are similar to partnerships and LLCs in this respect and are considered “pass-through entities.” S corps have specific legal and administrative requirements that business owners must follow to maintain S-corp status.
What is the difference between C corp and S corp?
The main difference between a C corporation and an S corporation is the way they’re taxed. C corporations pay taxes on their profits at the corporate level, and then again when they distribute profits as dividends to shareholders.
In contrast, S corporations are pass-through entities, meaning that profits and losses are passed through to the shareholders and reported on their personal tax returns. That said, S corps have additional restrictions, such as a limitation on the number of shareholders and the types of stock they can issue.
How does an S corporation work?
An S corporation is a popular choice for small business owners who want the limited liability protection of a corporation and the tax advantages of pass-through taxation. However, it’s essential to consider the specific requirements, restrictions, and responsibilities that come with this type of business structure before making a decision.
To become an S corporation, a company must first incorporate as a regular C corporation by filing the Articles of Incorporation with the Secretary of State in the state where the business is located.
Then, the corporation must file IRS Form 2553, “Election by a Small Business Corporation,” to be treated as an S corporation for tax purposes. This election must be made within two months and 15 days from the beginning of the tax year when the S corporation status is intended to become effective.
S corporations can have a maximum of 100 shareholders. Only U.S. citizens, resident aliens, certain trusts, estates, and tax-exempt organizations can be shareholders. Partnerships and corporations aren’t allowed to be shareholders in an S corporation. Additionally, S corporations can have only one class of stock.
Unlike C corporations, which are subject to double taxation (once at the corporate level and again at the shareholder level), S corporations enjoy pass-through taxation. This means that the company’s income, deductions, and credits flow through to the shareholders, who report this information on their individual tax returns.
Because of this workaround, S corps avoid the double taxation issue and can be beneficial for many small businesses.
S corps, like C corps, must follow certain corporate formalities, such as holding annual shareholder and board of director meetings, maintaining corporate records, and issuing stock certificates.
Limited liability protection
Shareholders of an S corporation have limited liability protection, which means that their personal assets are generally protected from the debts and liabilities of the business.
However, this protection is not absolute, and shareholders may still be held personally liable in certain situations. For instance, this may be the case if they personally guaranteed a loan or engaged in fraudulent activities.
S corporation shareholders who work for the company are considered employees and must receive a reasonable salary. These salaries are subject to payroll taxes, such as Social Security and Medicare taxes.
However, any remaining profits can be distributed to shareholders as dividends, which are not subject to these employment taxes, potentially providing some tax savings.
Pros and cons of forming an S corp
While there are many advantages to forming an S Corporation, there are also several requirements and limitations to consider. Before forming an S corp for your business, make sure it’s the right choice by weighing the pros and cons below.
Here is a list of the benefits and drawbacks to consider.
- Pass-through taxation
- Limited liability protection
- Raise capital through the sale of stock
- Establish a retirement plan for employees
- Eligibility requirements
- Shareholder limitations
- Administrative and legal requirements
- Potential for increased scrutiny by the IRS
- Pass-through taxation. One of the major benefits of an S corp is that the business’s profits and losses are passed through to the shareholders’ personal tax returns directly.
- Limited liability protection. S corps offer liability protection to their owners, meaning that the owners are not personally responsible for the company’s debts and liabilities.
- Raise capital through the sale of stock. S corps can issue stock to raise capital, which can be an attractive option for investors. This allows the business to raise funds without taking on debt.
- Establish a retirement plan for employees. S corps can establish retirement plans, such as a 401(k), for their employees. This can be a valuable benefit for attracting and retaining talented employees.
- Eligibility requirements. To qualify as an S corp, your business must meet several eligibility requirements. This includes being a domestic corporation, having no more than 100 shareholders, and only having one class of stock.
- Shareholder limitations. S corps have limitations on who can be a shareholder. For example, only individuals, certain trusts, and estates are eligible to be shareholders. Additionally, shareholders must be U.S. citizens or residents.
- Administrative and legal requirements. S corps have additional administrative and legal requirements compared to other types of business structures. This includes filing Articles of Incorporation with your state, holding annual shareholder meetings, and maintaining proper corporate records.
- Potential for increased scrutiny by the IRS. Because S corps offer pass-through taxation, the IRS closely monitors them to ensure that shareholders properly report their share of the company’s profits and losses on their personal tax returns. This means that S corps may be more likely to face an audit than other types of businesses.
Is an S corporation right for your business?
Determining whether an S corporation is the right choice for your business depends on several factors.
- Will your business benefit from avoiding federal income tax through double taxation?
- How many shareholders do you plan to have?
- Do you want to offer more than one kind of stock?
- Is limited liability protection enough for your business?
- Can you stay updated on new administrative and legal requirements?
- Is it smart to form an S corp while in this industry and location?
Ultimately, the decision to form an S Corp should be based on a thorough evaluation of your business’s needs and goals. Consulting with a qualified attorney or accountant can help you determine which structure is best for your specific situation.
What is an S corp example?
A family-owned restaurant could incorporate as an S corp and have the profits and losses passed through to the shareholders, who are typically family members. This would allow the business to avoid paying federal income tax at the corporate level and instead only pay taxes at the individual shareholder level.
- S corporations are a type of pass-through entity that allows small businesses to avoid double taxation.
- Rather than taxing at the corporate and individual level, S corps pass these profits and losses through to the shareholders, who report them on their personal tax returns.
- Forming an S corp requires filing articles of incorporation and meeting other legal and administrative requirements.
- Consulting with a qualified attorney or accountant is important before making the decision to form an S Corp.
View Article Sources
- S Corporations — IRS
- What is the S Corporation Association? — S Corporation Association
- S Corporations — California Tax Service Center