An S corporation is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation by electing to be treated as an S corporation.
An S corp is a corporation with the Subchapter S designation from the IRS. To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits the financial liability for which you are responsible. Liability protection is limited – S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident.
What makes the S corp different from a traditional corporation is that profits and losses can pass through to your personal tax return. Only the shareholders are taxed, however: any shareholder who works for the company must pay him or herself “reasonable compensation.”
Forming 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.
- Once your business is registered, you must obtain business licenses and permits.
- 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. You’ll have to make a special election with the IRS to have the LLC taxed as an S corp using Form 2553.
The LLC remains a limited liability company from a legal standpoint, but for tax purposes it’s treated as an S corp.
Taxes
Most businesses need to register with the IRS. Register with state and local revenue agencies.
All states do not tax S corps equally. However, some states tax S corps on profits 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 tax both the S corps profits and the shareholder’s proportional shares of the profits.
Your corporation must file the Form 2553
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.
- Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses.
- Independent Life. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.
Disadvantages of an S Corporation
- Stricter Operational Processes. S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.
- 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.