S Corporation:
Advantages and Disadvantages, How They Work

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What is an S Corporation?

An S Corporation sometimes called an S Subchapter, is one type of legal entity that can be established to operate a business. When a business owner chooses to incorporate their company as an S Corporation, their business must meet specific IRS requirements.

These requirements include:

  • No more than 100 principal shareholders or owners
  • Owners must be US citizens or permanent residents
  • The company cannot be owned by any other corporate entity including other S Corps, C Corps , LLCs , business partnerships, or sole proprietorships
  • Required board of directors
  • Required annual meetings
  • Strict regulations on corporate bylaws
  • Strict regulations on issuing stock shares

Forming an S Corporation is similar to forming any other business. Depending on your state business laws, to start your S corporation, you will need to complete the following steps.

  1. Business Name: Your business needs a unique name that does not infringe on any registered trademarks.
  2. Appoint a Board of Directors: The IRS mandates that to be an S Corporation, there must be a board of directors. The board of directors is your business’s governing body. The IRS also requires that the board hold regularly scheduled meetings and keep minutes for these meetings.
  3. File Articles of Incorporation: Corporate articles of incorporation must be filed with both the IRS and the Secretary of State. This allows your company to be recognized as a legally operating corporation.
  4. Write and File Corporate Bylaws: Corporate bylaws are mandated by the IRS for a corporation to be classified as an S Corp. Bylaws will outline the process for electing and removing directors from the board, how stock is sold and distributed, when meetings will be held, voting rights, and how the death of a director will be handled.
  5. Issuance of Stock to Shareholders: Once the corporate bylaws establish how stock will be distributed, a corporation can issue stock to the company’s shareholders. S Corps can be in the form of either common stock or preferred stock.

For more information about S Corporations and business formation, click here.

Advantages of S Corporations

S Corporations provide several advantages to shareholders, most notably in the areas of liability protection and taxes.

S Corps are separate legal entities from the company’s shareholders so shareholders benefit from liability protection. If there is a lawsuit against the company or the company is facing collection from creditors, the personal assets of shareholders are protected.

Forming an S Corporation provides the shareholders with many tax benefits. S Corps are a pass-through entity . Pass-through taxation allows the profits and losses from a company to pass through to the owners. This avoids paying federal taxes at the corporate level.

Some other advantages include:

  • Shareholders can be considered employees and draw an employee salary from the business
  • Shareholders can receive dividends and other tax-free distributions
  • The ability to transfer interests or adjust property basis without facing tax consequences
  • Establishing an S Corporation gives your business credibility that it may not gain under a sole proprietorship or an LLC

If you are unsure that an S Corporation is the right business structure for your company, read this article to learn about other business entity options.

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How Are S Corporations Taxed?

S Corps are pass-through entities. That means the corporation is not subject to federal income tax like a C Corporation. Much like a partnership or a multi-member LLC , shareholders of an S Corp are taxed based on their allocated share of income.

Shareholders are required to report all financial information relating to the business on their individual tax returns and pay taxes at their regular income rates. This allows shareholders to avoid the double taxation usually associated with a corporation.

Several forms need to be filed with the IRS for S Corps taxes. The first form is Form 2553 which is the “Election by a Small Business Corporation” form. This form proves that the business meets all the requirements set forth by the IRS to be an S Corp.

For state taxes, every state has its own laws and regulations regarding S Corp taxation. Some states have rules like the federal government in which the corporation is not taxed, while other states require S Corps to pay a state income tax.

S Corporation vs. LLC

S Corp and LLC Similarities:

  • An S Corporation and an LLC both offer liability protection to the business owners and shareholders. Both business entities are legally separate from the owner or shareholders. In the event of a lawsuit or a creditor collection, the owner’s personal assets are protected from business risks and debts.
  • S Corps and LLCs are both pass-through entities. Neither business pays corporate taxes and both entities require that the owner or shareholders report earnings and losses on their personal tax return avoiding corporate double taxation.

S Corp and LLC Differences:

  • LLCs are simpler to set up and less expensive to maintain. They are not subject to strict IRS guidelines and are not required by law to have a board of directors, bylaws, or meetings.
  • S Corporations provide better opportunities for securing outside financing. Unlike an LLC, S Corps have shareholders and can issue stock to investors.
  • An LLC can be dissolved if a member or an owner withdraws from the business. An S Corp tends to have perpetual existence.
  • LLCs provide more flexibility for owners and allow owners to maintain more control over their business

Choosing which entity to form for your business will depend on your individual business needs. A business run by a single owner who wants to maintain full control of their company and have flexibility should choose an LLC.

If there are several owners involved in a business and the business will be seeking investors for additional funds, then an S Corp formation would be more beneficial.

For more information about LLCs, click here .

S Corporation vs. C Corp

S Corp and C Corp Similarities:

  • S Corporations and C Corporations are both incorporated business entities governed by federal and state corporation laws.
  • Both corporation structures offer liability protection to the owners
  • S Corps and C Corps are required to have a board of directors, corporate bylaws, and hold regularly scheduled shareholders meetings

S Corp and C Corp Differences:

  • C Corps are subject to federal corporate taxes at a rate set by the federal government. C Corps are required to pay taxes on 21% of their income and then shareholders will also pay tax on the dividends they receive. This is usually referred to as “double taxation”.
  • S Corps are exempt from corporate taxes so shareholders will only pay taxes on income once, on their personal tax returns.
  • C Corps benefit from several tax advantages like deductions of charitable contributions from their earnings and the availability of untaxed benefits for employees.
  • S Corps are strictly regulated by the IRS, so C Corps offer more flexibility and ownership options than an S Corp.
  • Shareholders of a C Corp do not have to be US citizens or permanent residents.
  • C Corps have more options for classes of stock.
  • C Corps have fewer restrictions when it comes to raising funds.

If you are planning to incorporate your business and still are not sure about which structure to choose, seeking the advice of a corporate lawyer could be helpful.

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