What is an S Corp?

Seeing your small business start to succeed and grow into a well-established company is a dream come true for entrepreneurs. But as your company grows, your tax rate tends to grow too. Growing companies face a variety of complexities during tax season, and that’s why when your company starts growing, you may want to consider forming an S Corporation, otherwise known an S Corp. The S Corp is a business entity that offers significant tax advantages while still preserving your ownership flexibility.

An S Corp, also known as the sub-chapter or small business corporation, is a tax code that was enacted into law by Congress in 1958. The S Corp was created to encourage and support the creation of small and family businesses, while eliminating the double taxation that conventional corporations were subjected to.

How Is an S Corp Different from a C Corp or an LLC?

Unlike traditional C Corporations, also called C Corps, the S Corporation is not subject to corporate income taxes. Instead, the S Corporation receives different treatment for tax purposes that is generally more favorable to the business owner. The S Corp is a pass-through entity for tax purposes, similar to the LLC. This means that the income generated by an S Corporation will flow through to the personal income tax returns of the shareholders, and the S Corp itself generally does not owe any tax liability.

Structuring your business as an S Corp also gives you certain flexibility for managing the ownership of the company. The stock of S Corporations is freely transferable, while the interest (ownership) of LLCs is not. This means that the shareholders of S Corporations can sell their ownership interest without obtaining the approval of the other shareholders.

Another area of concern for business owners is reducing their liability for self-employment taxes, and an S Corporation can have an advantage over an LLC in this area as well.

The compensation (salary and bonuses) of S Corporation shareholders is subject to self-employment tax, but not the profits automatically allocated to them as a shareholder. Depending on how you pay yourself throughout the year, and depending on how your income appears on your personal tax return, you can effectively minimize your tax burden by reducing the amount of your business profits that are subject to self-employment taxes.

Although the S Corporation offers significant tax advantages and ownership flexibility, it is not the right choice for every business. There are a few restrictions as well.

An S Corporation must adhere to the following limitations:

• It may not have more than 100 shareholders.
• It is required to be a domestic business entity.
• The shareholders of the S Corporation must be US Citizens or legal residents of the United States.
• The S Corporation is restricted to only one class of stock.

Depending on your long-term business goals – for example, if you want your company to be publicly traded, or if you want to have international shareholders, a C Corporation might be a better choice of business entity, because C Corporations have no limitations on ownership and can offer multiple classes of stock. But if you are a U.S.-based business and are satisfied to work and grow within these limitations, the S Corporation can save you a lot of money and avoid a lot of hassles as your company expands.

How to Qualify for S Corporation Status

According to the IRS, to qualify for S Corporation status, a business must meet these requirements:

• Be a domestic corporation
• Have only allowable shareholders – which may include individuals, certain trusts, and estates, but not partnerships, corporations or nonresident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

The corporation must also submit Form 2553 to elect S Corporation status for tax purposes.

Advantages of Forming an S Corp

S Corporations offer several advantages if your company qualifies:

• Tax advantages: S Corporations are exempt from federal income tax except for certain capital gains and passive income. Similar to the LLC, the S Corporation allows profit to pass through to its shareholders, and the income is then taxed on the shareholders’ personal tax returns at each shareholder’s individual tax rates. Because the S Corporation is a pass-through entity, this ensures that the corporation’s profits are only taxed once – at the shareholder level. This means that S Corporations avoid having to pay what is often referred to as “double taxation” of dividends.
• Asset protection: If your business is an S Corporation, you have certain legal protections for your personal assets which are separate from the assets of the business. For example, shareholders are not personally liable for the company’s debts or liabilities, and for the most part, creditors are not able to go after the shareholders’ personal assets in order to recover business debts.
• Flexible characterization of income: Being an owner of an S Corporation gives you flexibility in how to characterize your income for tax purposes. As the owner/shareholder of an S Corp, you can be an employee of the business and pay yourself a salary. In addition to your salary, you can also pay yourself dividends from the S Corporation or distributions that are generally tax-free or taxed at a lower rate than the employee’s salary. This helps you reduce your self-employment tax liability, as long as you are characterizing your salary and dividends/distributions in a reasonable way. The IRS does not want to see you paying yourself an artificially low salary in order to avoid paying self-employment taxes on the “dividend/distribution” portion of your income.
• Easy transfer of ownership: S Corporation ownership interests are easy to transfer to other owners without causing significant tax consequences or terminating the corporate entity. An ownership transfer of an S Corporation does not require adjustments to property basis or compliance with complicated accounting rules.

Drawbacks of an S Corporation

The S Corporation structure is not right for every business’s situation, and it presents certain drawbacks and downsides:

• Restrictions on Ownership: S Corporations do not have the same degree of flexibility in their ownership structure, compared with a C Corporation. S Corps can only offer one class of stock, which limits the appeal to different types of investors. Also, the S Corp can only have 100 shareholders (or fewer) and cannot be owned by foreign shareholders or by certain trusts or other corporate entities.
• Caution about Wages and Dividends: One of the great aspects of the S Corporation is its flexibility in characterizing income as wages or dividends, but this can also present challenges. The IRS is always on the lookout for business owners that are not fairly or accurately characterizing their payments of wages, so as an S Corporation owner, you have the risk of being asked to re-characterize some of your income and pay higher taxes as a result.
• Tax Qualification Mistakes: This is a rare scenario, but it does happen – sometimes, S Corp owners will make mistakes related to their IRS form filing requirements related to stock ownership, election, consent, notification and other aspects of running an S Corp, and this can cause the company to lose its S Corporation status.

Would you like to set up your business as an S Corporation, or set up your LLC to file as an S Corporation? If so, you can choose S Corporation status for tax purposes by filing IRS Form 2553 within 75 days of the filing date of the company or by filing IRS Form 2553 by March 15 of the tax year the election is to take effect, or any time during the tax year prior to the tax year it is to take effect.