If you’re considering opening a new business, one of the first things you’ll need to decide is what type of entity you want to run. Entity options typically include sole proprietorships, partnerships, limited liability companies, and C corporations, among others. One option that tends to confuse business owners is an S corporation, or “S corp” for short.
What is an S corporation? According to the Internal Revenue Service (IRS), “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits to their shareholders for federal tax purposes.”
So an S corp is not necessarily a type of business structure as much as it is an elected tax status. In this article, we’ll dive deeper into what S corps are so that you can determine whether this option is best for your small business corporation.
What is an S corporation?
An S corporation is essentially a regular corporation that has applied for “S corporation” tax status. S corp shareholders report pass-through income on their personal income tax returns. By reporting income here, S corporation shareholders avoid double taxation.
Double taxation occurs when business income is taxed twice — once at the corporate tax rate, and then again at the personal tax rate when reported by shareholders on their individual tax returns.
The tax benefits are not the only advantages offered by an S corp. S corp status also protects against personal liability. This means that — generally speaking — shareholders are not responsible for any debts or liabilities accrued by the business. The only way that liability protection would not exist would be if the shareholder offered a personal guarantee.
But let’s say you’re a small business owner who elects S corp status. You could offer shares to investors while minimizing their potential risk. Investors can purchase shares of your company without having to worry about being held accountable if the business goes under.
The tax advantages and liability protection offered by S corp status make it an attractive option for small business owners. However, before you elect S corporation status, you need to make sure you meet four criteria. You also need to maintain these criteria throughout the lifespan of your business. The business:
- Must be a domestic corporation, operating in the United States
- May not have more than 100 shareholders
- Must have only one class of stock
- Must only have allowable shareholders. Other corporations, partnerships, and non-resident aliens may not be shareholders of the company.
Additionally, there are only certain companies eligible to elect S corp status. While a good majority can, businesses like insurance companies, financial institutions, and some domestic sales corporations operating internationally are not qualified. Examples of those forbidden from operating as an S corp include:
- Credit unions
- Any insurance company
- Any business that receives more than 95% of its gross income from exports
- Corporations that use a specific type of foreign tax credit known as a possessions tax credit
If you don’t operate one of these companies, then an S corp could be attractive because of the tax advantages and liability protection that it offers. However, before electing to file as an S corp, there are a few disadvantages you’ll want to consider as well.
The disadvantages of S corps
There are a few downsides to choosing S corp status. The first is that businesses limit their shareholder pool significantly. Companies can’t have more than 100 shareholders. These shareholders must be US citizens, residents, or resident aliens. Additionally, shareholders cannot be other partnerships or corporations. These requirements could cut down on the investor pool significantly.
If businesses are caught breaking these rules, they’re subject to three years of back-taxes from the IRS. And the IRS will revoke S corp status immediately. Once a business loses S corp status, they cannot reapply for another five years.
There could also be potential downsides to the perceived tax filing benefits. Because income is paid based at the individual level on personal tax returns, shareholders in a higher tax bracket will pay more in taxes.
The Internal Revenue Code calls for all businesses to pay a flat corporate tax of 21%. However, there are only two personal tax return rates lower than 21%. The personal tax return rates and the taxable income thresholds for unmarried individuals are as follows:
- More than $0 in taxable income will have a 10% rate
- More than $9,700 in taxable income will have a 12% rate
- More than $39,475 in taxable income will have a 22% rate
- More than $84,200 in taxable income will have a 24% rate
- More than $60,725 in taxable income will have a 32% rate
- More than $204,100 in taxable income will have a 35% rate
- More than $520,300 in taxable income will have a 37% rate
By having to report business income on personal returns, shareholders may find themselves in a higher tax bracket and paying more taxes.
Additionally, imagine the following scenario where two people own 25% of a company for a total of 50%. A business reports $100,000 in taxable income for the year. Both owners are responsible for paying taxes on $25,000 in income. Owner A does not have another job, so he has to pay taxes at the 12% rate. Owner B has another job and has another $60,000 income to report.
$60,000 in income, combined with the $25,000 profit from the S corp, pushes him into the 24% tax rate. So Owner B is paying considerably more in taxes than Owner A, even though they both have the same amount of equity in the company.
How to start an S corporation
Interested in choosing S corp filing status? Below is a step-by-step guide to creating an S corporation.
1. Create your business entity
If you wish for the IRS to consider you an S corp, you must first make sure your business is properly registered. Independent contractors and those paying self-employment taxes will want to consider sole proprietorships and single-member LLCs. Other options include partnerships and C corporations.
To incorporate your business, you will first need to determine which state you’ll incorporate your business in. A few things to consider include:
- Where your physical presence will be
- Where you will hire employees
- Where you will keep bank accounts
- Which states you will be accepting orders in
Once you have established these aspects, follow these steps:
- Make sure your business name is available in your state. You can use our guide to starting a business to find out if your business name is available, or you can search on your local Secretary of State website.
- Register a “Doing Business As” name. If your business name is anything but your actual name, file a fictitious business name — also called a “doing business as” or DBA — with your state.
- Prepare your articles of incorporation.You’ll need to file these with your local Secretary of State.
- Prepare the corporate bylaws. Bylaws need to summarize company rules surrounding operations, officer positions, and duties. In some cases, bylaws are not required by the state, but it is highly beneficial to create and maintain bylaws for your own records.
- Keep corporate minutesof all board and shareholders meetings. Minutes allow you to record and formalize decisions made during meetings, including but not limited to the appointment of board members, officers, and other relevant resolutions.
- Apply for an Employer Identification Number (EIN) with the IRS.An EIN allows you to hire employees, open a business account, and pay taxes. You can do so by preparing and submitting an IRS Form SS-4.
- Secure permits and business licenses. Depending on what type of corporation you’re starting, you may need both state and local permits to operate legally.
If you’re overwhelmed or confused during any stage of the process, consider contacting an attorney or an incorporation service company that specializes in handling this process.
2. Research whether you qualify for S corp status
As mentioned, there are several essential requirements you must meet to be eligible for S Corporation status. You’ll want to make sure that you meet these filing requirements before applying.
- Be an eligible, domestic corporation. Insurance companies, financial institutions, and some domestic sales corporations operating internationally are not qualified
- Have only one class of stock. This means you cannot have distinct stock types that are entitled to different treatment, such as class A and class B, or voting and non-voting shares.
- Have no more than 100 shareholders. All of them must consent to S corporation election.
- Have only shareholders that comprise of individuals. Partnerships, corporations, and non-residents cannot be shareholders.
Already have (or be prepared to adopt) one of the following tax years:
- Tax year ending on December 31.
- A natural business year (i.e., a one-year period that usually ends in a low point of activity).
- A tax year listed under Section 444 of the Internal Revenue Code.
- A 52 or 53-week tax year ending with reference to one of the above tax years.
- Any other tax year for which the corporation has established a business purpose (you will be asked to confirm this in IRS Form 2553).
3. File IRS Form 2553
Once your corporation is formed, you will need to file Form 2553 within these timeline restrictions:
- No later than two months and 15 days after the selected tax year begins.
- Any time during the tax year before the tax year that S corporation status will take effect.
If you can show a reasonable cause for failing to file on time, you can request a late election. Follow all directions on Form 2553 carefully. While forming an S corporation is a tedious exercise, failure to execute all requirements will revoke corporate personhood and liability protection, which could leave your personal assets vulnerable to seizure.
When filing the form, you’ll need the signatures of all of your shareholders. Once you’ve obtained these signatures, send the form to the correct office based on the principal location of your business.
Within 60 days of filing, the service center will notify you about whether your application was accepted. If you request a tax year based on “business tax purpose,” your application may take another 90 days. Once accepted, your S corporation tax status will remain in effect until it’s terminated or revoked.
Choosing the correct business filings
As a new business owner, you may find yourself overwhelmed with the various entity options available for your company. The ability to elect S corp status — which doesn’t impact your business structure — complicates this decision further.
S corps could be useful because they allow you to avoid paying corporate-level taxes and can provide liability protection. However, they place restrictions on your shareholders, and the tax benefits may not be all they’re cracked up to be.
Doing your research, consulting with a tax professional or attorney, and discussing the decision with your board of directors and shareholders will allow you to determine whether S corp status is the proper choice.