S Corporation
What is an S corporation?
An S corporation, or S corp, is a tax election through the IRS that helps certain businesses avoid double taxation. Under standard corporate taxation, profits are taxed at the corporate level and again at the shareholder level, but S corp profits pass through to shareholders' personal tax returns, so they only pay tax once at their individual tax rates.
How does an S corp work?
S corps function like regular corporations in terms of structure, but the taxation works differently. Profits and losses are reported on shareholders' personal tax returns, so each shareholder reports their share of the S corp's income based on their ownership percentage.
What are the requirements for an S corp?
To qualify as an S corporation with the IRS, you must meet the following requirements:
- The business must be organized and formed in the United States. Foreign corporations do not qualify, even if they conduct business in the U.S.
- S corps are limited to 100 shareholders.
- Only U.S. citizens, certain trusts, and estates qualify as shareholders. Corporations, partnerships, and non-resident aliens are not eligible.
- All shares must provide identical rights to distributions and liquidation proceeds.
- Certain financial institutions, insurance companies, and domestic international sales corporations cannot elect S corp status, regardless of whether all other requirements are met.
- Form 2553 must be filed no later than two months and 15 days after the start of the tax year you want the election to take effect.
What are the advantages of an S corp?
Pass-through taxation
One of the biggest tax advantages of an S corp is that it does not pay federal corporate income tax. Profits and losses flow directly to shareholders' personal tax returns, avoiding the double taxation that C corporations face, where income is taxed at both the corporate and shareholder level.
Potential self-employment tax savings]
Shareholders who work in the business must receive a reasonable salary and pay taxes on it. However, any additional profits distributed as dividends are not subject to self-employment tax, reducing total tax liability for small business owners.
Limited liability protection
Like a C corp, an S corp provides shareholders with limited liability protection. Personal assets are generally shielded from business debts.
Corporate credibility
Registering as an S corporation signals legitimacy to customers, suppliers, and potential investors. Businesses operating under a corporate structure are credible, established, and accountable.
Simplified asset transfer
Ownership may be transferred by selling shares, making the transfer of ownership easier than a sole proprietorship.
What are the disadvantages of an S corp?
Shareholder restrictions
S corporations have a cap of 100 shareholders and cannot allow specific types of businesses or individuals to hold shares. This limitation may limit your ability to raise money.
Strict IRS requirements
The IRS monitors S corps to ensure owners pay themselves a reasonable salary. Underpaying oneself to reduce payroll taxes may trigger audits or penalties.
One class of stock
Issuing only one class of stock limits the flexibility available in the distribution of profits when compared to C corporations.
Administrative formalities
S corps are subject to corporate formalities, including holding annual board meetings, maintaining proper records, and filing an annual report.