What is a S-Corp? Definition, Taxes, and How to File
What Is an S-Corp?
An S-corporation is a type of business entity that is legally allowed to pass all its wins and losses directly to its shareholders. This gives the S-Corporation certain advantages over the other forms of incorporation.
It is both similar and different to a limited liability company (LLC). While both entities pay no corporate taxes and instead pay their shareholders (who then pay their respective income taxes), an S-Corporation can be established only if the business has 100 or fewer shareholders.
Taxes
The key characteristic of passing wins and losses directly to shareholders makes the S-Corporation a pass-through entity. Notwithstanding this, S-Corporations remain liable to federal corporate taxes for specific built-in gains and for passive income.
Similarities to C-Corp
An S-Corporation is similar to any other corporation, or C-corporation. While it is a ‘for-profit company,’ it offers similar liability protection, ownership, and management advantages that a C-Corporation offers. An S-Corporation must also follow regulations subject to internal practices such as: establishing a board of directors; creating corporate bylaws; having shareholders’ meetings; and recordkeeping for significant company meetings.
The main difference between the two is how they are taxed. C-Corporations are subject to ‘double taxation;’ whereby profits get taxed when earned, and then after profits get disbursed to shareholders, do shareholders pay tax a second time as their regular income. By contrast, (with exceptions) an S-Corporation may pass income to shareholders without paying federal corporate taxes.
IRS Requirements for an S-Corp
In order to qualify for S-Corporation status, a business has to satisfy certain criteria: Incorporation must take place within the United States; offer only one class of stock; and have no greater than 100 shareholders. Additionally, shareholders can only be individuals, specific trusts and estates, or certain tax-exempt organizations. Shareholders cannot be nonresident aliens, or any kind of corporate entity.
How to Set Up an S-Corp
First, a business must be incorporated. Then it must file with the IRS an ‘Election by a Small Business Corporation’ form. From there, the IRS reviews your form/petition and will accept your S-Corporation status only if both: All shareholders have signed the consent statement, with an officer having signed below; and the exact name and address of the corporate entity (and other required form information) are provided.
Advantages of Registering As an S-Corp
Corporate tax savings. Businesses that register as an S-Corporation benefit by avoiding ‘double taxation.’ This is particularly beneficial when a business is still new.
Personal income tax savings. S-Corporation owners can lower their liability for self-employment tax, by characterizing their earnings as salary or dividends. There are also deductions for business expenses and for wages paid to their employees.
Corporate dividends. Shareholders can be company employees, can earn salaries, and even receive corporate dividends. If distributed dividends do not exceed their stock basis, then they are tax free. However, if dividends do exceed a shareholder’s stock basis, then any money beyond that stock basis is taxed as capital gains.
Special status for asset transfers. S-Corporations don’t have to follow complicated accounting rules, and can freely transfer interests or adjust property bases.
Disadvantages of Registering As an S-Corp
IRS scrutiny: S-Corporations can disguise salaries as corporate distributions to avoid paying payroll taxes, and the IRS doesn’t look kindly on that. An S-Corporation must first pay reasonable salaries to its shareholder-employees; and then once that obligation is satisfied, can it make distributions.
Restricted distribution rules: The S-Corporation has to follow strict guidelines when it makes distributions to stakeholders. It can only allocate profits and losses proportionate to either what percentage of ownership (equity) an individual holds, or to the number of shares each shareholder owns.
Costly and Time Consuming: The business owner has to: submit articles of incorporation with the Secretary of State in the business’s home state; get a registered agent for the business; appoint and be governed by a board of directors, which must conduct meetings, and perform recordkeeping; and pay whatever costs there are for incorporation.
Fees: There are annual report fees, maybe a franchise tax (depending on whether you’re contracted with a franchisor), and other miscellaneous sums. Furthermore, all investors, even ones which do not have voting rights, receive dividends and have distribution rights.
Limits on growth: If your business is poised for expansion, or is looking for outside investors or capital, then the limits on the number and nature of shareholders might hinder your interests.
S-Corp vs. LLC
A limited liability company (LLC) is another type of hybrid. Also like S-Corporations; both forms are pass-through entities, , and both offer limited liability protection for their owners.
However, S-Corporations are less flexible than LLCs. LLCs aren’t subject to the IRS’ shareholder regulations, nor do they have to establish a board of directors, be subjected to the same recordkeeping requirements. Unlike an S-Corporation, an LLC can even disburse its profits/losses however its owners wish.
