S Corporation
An S Corporation or S Corp is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.
An S Corp is a corporation that has received the Subchapter S designation from the IRS. A business must first be chartered as a corporation in the state where it’s headquartered to be considered an S Corp. According to the IRS, S Corporations are "considered by law to be a unique entity, separate and apart from those who own it." This allows for a limit on the financial liability for which an owner (aka "shareholder") is responsible. Nevertheless, liability protection is limited – S Corps do not necessarily shield owners from all litigation such as an employee’s tort actions as a result of a workplace incident.
What differentiates the S Corp from a traditional corporation (C Corp) is the ability to have profits and losses pass through to the shareholder’s personal tax return. Consequently, the business is not taxed itself, only the shareholders. There is an important caveat, however: any shareholder who works for the company must pay him or herself "reasonable compensation." Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as "wages."
Forming an S Corporation
Before you form an S Corporation, determine if your business will qualify under the IRS stipulations.
To file as an S Corporation, you must first file as a corporation. After you are considered a corporation, all shareholders must sign and file Form 2553 to elect your corporation to become an S Corporation.
Like all businesses, S Corps must obtain all relevant business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing & Permits tool on sbcacommunity.com to find a listing of federal, state and local permits, licenses, and registrations you’ll need to run a business.
If you are hiring employees, read more about federal and state regulations for employers.
Combining the Benefits of an LLC with an S Corp
There is always the possibility of requesting S Corp status for your LLC. Your attorney can advise you on the pros and cons. You’ll have to make a special election with the IRS to have the LLC taxed as an S Corp using Form 2553. And you must file it before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect.
The LLC remains a limited liability company from a legal standpoint but for tax purposes it’s treated as an S Corp. Be sure to contact your state’s income tax agency where the election form will be filed. Ask them whether or not they recognize the S Corp election and what the tax requirements are.
Read more about the benefits of combining an LLC with an S Corp on sbcacommunity.com.
Taxes
Most businesses will need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit.
All states do not tax S Corps equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. However, some states like Massachusetts tax S Corps on profits that rise above a specified limit. Other states don’t recognize the S Corp election and treat the business as a C-Corp with all of the tax ramifications. Some states like New York and New Jersey tax both the S Corps profits and the shareholder’s proportional shares of the profits.
Your corporation must file the Form 2553 to elect "S" status within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect.
Read more about IRS filing requirements for S Corporations.
Advantages of an S Corporation
Tax Savings. One of the best features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a "distribution" which is taxed at a lower rate, if at all.
Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, then benefits like health and life insurance are deemed taxable income.
Independent Life. An S Corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S Corp can continue doing business relatively undisturbed. By maintaining the business as a distinct corporate entity, clearer lines are defined between the shareholders and the business that improve the protection of the shareholders.
Disadvantages of an S Corporation
Stricter Operational Processes. As a separate structure, S Corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance. Please refer to sbcacommunity.com’s Corporation page for more information.
Shareholder Compensation Requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. An audit could result in paying a higher employment tax.
