What are S corporations: Key benefits and more

What is an S corporation and why does it exist?

A corporation is a business entity formed under the laws of a corporation statute of a state. It has an existence separate and apart from its shareholder or shareholders.

Until 1958 all corporations, from the smallest to the largest, filed their own federal income tax return and paid taxes on their income. The part of the Internal Revenue Code that governs the corporate income tax is called Subchapter C. Corporations taxed under Subchapter C are therefore referred to as “C corporations”.

The income of a C corporation is subject to “double taxation”. The corporation pays income taxes and the income it distributes to its shareholders as dividends is taxed again as personal income to the shareholders.

For years, small businesses complained that double taxation was making it hard for them to succeed. In 1958, Congress amended the Internal Revenue Code to provide small businesses with relief from double taxation. They added Subchapter S to the Internal Revenue Code — the subchapter which gives us the name “S corporation”.

An S corporation, therefore, can be defined as a corporation that elects to be taxed under Subchapter S of the Internal Revenue Code. It is important to note that the only difference between an S corporation and a C corporation is in how they are taxed under the Internal Revenue Code. There is no distinction in the state corporation statutes.

How is an S corporation taxed by the IRS?

S corporations are taxed by the IRS as pass-through entities. Because of pass-through taxation, the S corporation doesn’t pay federal income tax on its business income the way a C corporation does.

Instead, business income, deductions, losses, and other tax items flow through (or pass through) to the business owners (e.g., the shareholders). The S corporation files an information return (Form 1120S) with the IRS stating each owner’s share. Business owners must pay tax on their share of the S corporation’s income, even if the money stays in the business instead of being distributed.

For a small business, operating as an S corporation avoids the “double-taxation” that would otherwise be paid if both the corporation and shareholder paid tax on the income distributed to its shareholders.

What corporations can be S corporations?

Not every corporation qualifies for S corporation tax status. Subchapter S places a number of restrictions on corporations, including the following:

• Shareholders have to be individuals, certain types of trusts, estates, or certain types of tax-exempt organizations. For example, a partnership can’t be an S shareholder.
• The corporation must be a U.S. corporation with no more than 100 shareholders. (Related parties may count as a single shareholder.)
• The corporation can have only one class of stock — but differences in voting rights among shares of common stock are permissible — and it can’t have a nonresident alien shareholder.

Also, some types of businesses (e.g., financial institutions and insurance companies) aren’t eligible for S corporation tax status even if they otherwise meet the IRS requirements.

An S corp must continue to meet these requirements. If the corporation fails to comply — for example, if it sells shares to more than 100 individuals or to a corporation, partnership, or citizen of a foreign country, or creates more than one class of stock — it will no longer be eligible to be an S corp.

Advantages of S corporations over LLCs

An LLC can also avoid double taxation. Unless the owners of the LLC (called members) choose otherwise, an LLC with one member is disregarded as an entity and its income is considered the member’s income. A multi-member LLC is taxed like a partnership, with its income passing through to the members.

Although both provide pass-through taxation, there are some advantages of choosing an S corporation over an LLC including the following:

• S corporation dividends escape self-employment tax (unlike LLCs). One of the main advantages of S corporation taxation has to do with employment taxes like Medicare and Social Security. In an S corporation, a shareholder who also works for the corporation is considered both an owner and an employee. If the shareholder pays himself or herself a reasonable salary and takes the rest of the profits as a dividend, only the salary is subject to employment taxes, not the dividend.
  
  In LLCs that are disregarded entities or taxed like partnerships, a member who works for the LLC is only considered an owner, and the entire distribution of profits is subject to self-employment taxes. (Be aware that the IRS closely watches this opportunity for splitting compensation and dividends. It may challenge salaries that aren’t “reasonable” in its view and try to recharacterize dividends as salary.)
  
  
• Compared to LLCs, S corporations can more easily convert to C corporations. The owners of some startups plan on eventually obtaining financing from private equity funds or other outside investors. These investors will often only invest in C corporations. Others may eventually plan on an IPO (which an S corp can’t do because of the restrictions on the number and type of shareholders).
  
  If the owners want pass-through taxation in the early years, they may choose an S corporation over an LLC because an S corporation is the same entity as a C corporation and only has to make a filing with the IRS to change its tax status. An LLC is a different entity from a corporation and will have to convert pursuant to the provisions of the state corporation law and state LLC law.

Disadvantages of S corporations over LLCs

There are also some disadvantages, including the following:

• LLC is a more flexible entity. Many small business owners prefer an LLC over a corporation because it is more flexible — both in how it is managed and in how it can split financial and management rights. For example, with an S corp, earnings must be distributed proportionately to capital contributions. LLCs are not similarly limited.
  
  
• LLCs can provide pass-through taxation without Subchapter S restrictions. An LLC can provide pass-through taxation without the restrictions on the number and type of shareholders, classes of ownership interests, etc. to which an S corporation is subject.

If I want to operate my business as an S corporation, what do I do?

It is important to remember that an “S corporation” is not a business entity type. A corporation is a business entity type. An S corporation is simply a corporation whose shareholder or shareholders have elected to have their corporation taxed under Subchapter S of the Internal Revenue Code. Therefore, the first step for anyone wanting to use the S corporation structure is to form a corporation.

The steps in the incorporation process generally include choosing a state of incorporation, selecting a corporate name, choosing a registered agent, and drafting and filing your articles of incorporation with the Secretary of State (or similar state filing office).

The state corporation laws do not distinguish between S corps and C corps. Therefore, it is also important to remember that the S corp will have to comply with all of the requirements of its home state’s corporation law, including, in general, filing an annual report, paying franchise taxes, notifying the state of a change in registered agent or office, holding meetings, maintaining corporate records, and so on.

By default, every corporation will be taxed as a C corporation. Therefore, after forming your corporation, you have to properly make an IRS election to get S corporation tax treatment. This is done by filing Form 2553 with the IRS.

There’s no wait-and-see: S elections are due as your tax year begins

For a qualifying corporation to obtain S corp tax treatment, an S corp election has to be properly made using the correct forms and within a certain period of time. If the election isn’t made by the deadline for the current tax year, the S corp election will take effect for the corporation’s next year.

Elections for a tax year are due in the early part of that tax year, within a certain window. It has to be made during the corporation’s tax year and on or before the 15th day of the third month of its tax year.

For new corporations, the tax year almost never begins on January 1. It’s always a good idea to file the election early so you don’t have to worry whether you made it in under the deadline for your first tax year.

A proper S corp election is effective for all succeeding years until it’s terminated (either by you voluntarily, or by the IRS for violating S corp rules). You don’t have to keep electing every year.

All shareholders need to consent to the election. Without this unanimous consent, the election won’t be valid.

Conclusion

An S corporation is a corporation that “passes through” its income, expenses, and losses to the shareholders in proportion to their ownership interest in the S corp. Being taxed as an S corporation can result in savings on federal income taxes. (Many, although not all states, will also tax an S corporation as a pass-through entity for state income tax purposes.)

In addition, for corporations where the owners also work for the corporation, an S corporation can save on the owner’s self-employment tax.

Of course, the type of business entity that a small business owner chooses depends on many factors. But if S corporation benefits appeal to you, talk to your advisor.