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What is an S Corp?
An S Corp, or sometimes called an S Subchapter, is one type of incorporated legal business entity. An S Corp has a similar business structure to a limited liability company and a C Corporation but what makes it different are distinct characteristics that meet specific IRS requirements.
An S Corp will protect a business owner from certain liabilities just like an LLC or a C Corp. The business is a separate entity from the owner so if there is a lawsuit or debt collection against the company, the owner’s personal assets are protected.
One great advantage of an S Corp is that it is a pass-through entity like an LLC. This allows business income, losses, deductions, and credit to pass directly to shareholders without paying federal corporate taxes.
To have your business qualify for an S Corp, it must meet strict requirements set by the IRS. These requirements include:
- No more than 100 principal shareholders or owners
- Owners must be US citizens or permanent residents
- 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 shareholder meetings
- Strict regulations on bylaws
- Strict regulations on issuing stock shares
Forming an S Corporation is similar to forming any other business. If you are ready to start your business and have decided that an S Corp is the right structure, you can follow these steps.
- Step 1: Name Your Business: Your business needs a unique name that is not already being used by another S Corp in your jurisdiction. You can contact your local state business offices to find out where to get a list of current S Corps to see what names are being used.
- Step 2: Set Your Board of Directors: Every S Corp is required to have a board of directors. The board of directors is your businesses governing body that represents the shareholders of the company. One of the requirements of forming an S Corp is that this board needs to have regularly scheduled meetings and keep minutes for these meetings. The board will also develop policies for managing the company.
- Step 3: File Articles of Incorporation: When forming an S Corp, articles of incorporation must be filed with both the IRS and the Secretary of State. You must follow the rules and regulations of your state pertaining to filing articles of incorporation.
- Step 4: Issue Stock: S Corps can be in the form of either common stock or preferred stock
- Step 5: File Corporate Bylaws: Bylaws are another area of the S Corp that is strictly regulated by the IRS. Bylaws will outline the process for electing and removing directors from the board, how shares are sold, when meetings will be held, voting rights, and how the death of a director will be handled.
- Step 6: File Form 2553 with the IRS: After your S Corp has been approved by the Secretary of State, you must file the Election by a Small Business Corporation form with the IRS. This is form 2553 and it makes your company official with the IRS.
- Step 7: Assign and File a Registered Agent: Depending on your state, you may be required to appoint a registered agent for your S Corp. The registered agent will oversee receiving all legal documents between the company and government agencies.
If you would like more information about the IRS requirements for an S Corp, continue reading here.
Advantages of S Corps
S Corps provide several advantages to business owners and these advantages generally outweigh any potential disadvantages.
The most prominent advantage is the tax benefits that go along with forming an S Corp. S Corps are pass-through entities, so they do not have to pay federal taxes at the corporate level. This allows business losses to offset shareholder’s income reducing the amount of taxes paid.
S Corp shareholders also can be considered employees and draw an employee salary from the business. Other advantages to shareholders include receiving dividends and other tax-free distributions.
Just like an LLC, an S Corp protects the personal assets of its shareholders. A shareholder will not be personally liable for any business debts or company liabilities.
Another advantage to forming an S Corp rather than a C Corp is the ability to transfer interests or adjust property basis without facing tax consequences or being forced to comply with complicated accounting rules.
Finally, establishing an S Corp will give your business credibility that it may not gain under a sole proprietorship or an LLC. Suppliers, investors, and customers may be more inclined to work with a corporation because it shows a commitment to not only the company, but the shareholders as well.
Although the advantages to an S Corp generally outweigh the disadvantages, if you are considering forming an S Corp you should consider these potentially negative aspects:
- Some states do not allow S Corp income to be taxed on the owner’s personal tax returns
- There are numerous fees associated with an S Corp like filing fees for annual reports and articles of incorporation
- S Corps are more difficult to establish and maintain than an LLC due to requirements of board of directors, annual shareholder meetings, and regulations on stock issuance
- Owner of the company has less control than with an LLC or sole proprietorship
How Are S Corps Taxed?
S Corps are a pass-through entity so instead of being taxed like a corporation, they are actually taxed similarly to an LLC. Business income, losses, deductions, and credits will pass directly to shareholders avoiding federal corporate taxes.
S Corp shareholders will 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.
There are several forms that need to be filed with the IRS for an 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.
Even though an S Corp is exempt from corporate taxes, the business still needs to file taxes and report its earnings to the federal government. This is done with Form 1120-S which reports the business income, loss, dividends, and other distributions passed from the business to the shareholders.
S Corp vs. LLC
S Corps and LLCs share many similarities, and both have their advantages and disadvantages.
An S Corp and an LLC offers the same liability protection to the business owner. Both business entities are considered separate from the owner. In the event of a lawsuit or a creditor collection, the owner’s personal assets are separate and protected from the business.
Both S Corps and LLCs are taxed in a similar manner in that they are pass-through entities. Neither business pays corporate taxes and, in both entities, the owner reports earnings and losses on their personal tax return avoiding double taxes.
LLCs tend to be simpler to set up and less expensive to maintain than an S Corp providing more flexibility for owners. This is due to the strict requirements that an S Corp must meet under the IRS guidelines.
If a business is looking to secure outside financing and big investors, an S Corp will be the better option because unlike an LLC, S Corps have shareholders and can issue stock to investors.
Another difference between these two business entities is that an LLC can be dissolved in the event that a member or an owner withdraws from the business. An S Corp tends to have perpetual existence.
While neither formation is “better” than the other, 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.
Another option for a business with multiple owners is an LLC Partnership. Click here to read about LLC Partnerships and how they work.
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S Corp vs. C Corp
S Corps and C Corps are similar in that they are both incorporated, for-profit companies governed by state corporation laws. They both offer liability protection to the owners, are comprised of a board of directors, must have corporate bylaws, and have shareholders meetings. The biggest difference between these two entities is the tax status.
C Corps are subject to federal corporate taxes which is usually described as a double tax. C Corps are required to pay taxes on 21% of their income and then owners will also pay tax on the dividends they receive.
S Corps avoid corporate taxes so owners will only pay taxes on income once, on their personal tax returns. For a smaller business just starting out, these savings on taxes can be extremely beneficial.
Unlike S Corps, C Corps do have several tax advantages to consider. A C Corp can deduct charitable contributions from their earnings. They can also offer untaxed benefits to their employees if 70% of employees receive the benefits.
Due to the strict regulations placed on S Corps by the IRS, C Corps offer more flexibility and ownership options than an S Corp. Owners of C Corps do not have to be US citizens or permanent residents and C Corps have more options for classes of stock. Furthermore, C Corps also have less 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 useful.
If you would like to read more about C Corps, check out this article.
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