An S corporation is a corporation that has elected to be taxed for federal income purposes under Subchapter S of the Internal Revenue Code instead of Subchapter C.
1. S corporation: Definition
An S corp is a corporation, formed under a state corporation statute, that has elected a specific tax status with the Internal Revenue Service (IRS). This election enables the corporation to pass its income, losses, deductions, and credits through to its shareholders. The shareholders pay income taxes on the S corporation’s income on their personal income tax return at their individual income tax rate. The corporation itself does not pay federal corporate income taxes.
An S corporation operates in the same manner as a corporation that has not elected S corporation tax status. A corporation that has not elected S corporation status is referred to as a C corporation. All corporations are taxed for federal income tax purposes as a C corporation unless they qualify for, and elect to be taxed as an S corporation.
Because the state corporation laws make no distinction between S corps and C corps (this is a tax issue only), S corps have to comply with all requirements of the corporation law under which they have been formed. That means, for example, that they will have to appoint and maintain a registered agent, and in most states they will have to file an annual report. They also must have directors, officers, and shareholders who function in the same manner as C corporations.
2. What is an S corp vs. a C corp?
The difference between an S corporation and a C corporation is in how they pay income taxes. An S corporation pays taxes under Subchapter S of the Internal Revenue Code (hence the name S corporation). A C corporation pays taxes under Subchapter C (hence the name C corporation).
An S corporation does not pay corporate income taxes. Its shareholder or shareholders pay the tax on the corporation’s income. A C corporation does pay a corporate income tax. By default, all corporations are taxed under Subchapter C. In order to be taxed under Subchapter S, the corporation must file an election form with the IRS.
See our article on S corp vs. C corp for more information.
3. How is an S Corp taxed?
If you elect S corp status for your corporation, the business’ income would not be subject to the federal corporate income tax. In the case of an S corporation with one shareholder, the IRS “disregards” the corporation and, as in the case of a sole proprietorship, the corporation’s income is considered the shareholder’s income.
In the case of an S corporation with more than one shareholder, the corporation’s income is said to “pass-through” to the shareholders. The shareholders pay income taxes on their share of the corporation’s income at their individual income tax rates.
Most state tax departments recognize S corps the same way the IRS does and tax shareholders accordingly. But not all states do. It is best to consult with a tax advisor on how S corps are taxed in the states where your corporation is incorporated and does business.
4. S corp advantages
Not all corporations can be taxed as an S corp. To qualify for S corp status, your corporation must meet the following criteria:
- Be a domestic corporation
- Have only allowable shareholders. These may be individuals, certain trusts, and estates but may not be partnerships, LLCs, corporations, or non-resident alien shareholders
- Shareholders are limited in number to 100
- Have only one class of stock. (There can be classes with different voting rights but not different economic rights, such as a preferred right to dividends or distributions.)
- Certain corporations may be barred from becoming an S corp, including certain financial institutions, insurance companies, and domestic international sales corporations
- In order to elect S corporation tax status, all shareholders must approve the election
5. S corp disadvantages
- Limited liability protection. The owner’s personal assets are protected against losses, debt, and claims against the company. This is an advantage over sole proprietorships and partnerships.
- Single level of taxation. This is considered the main advantage of an S corp over a C corp. In an S corp, income taxes are not paid at the corporate level. In a C corp, the corporation pays corporate income taxes and any distributions to shareholders are taxed again at the shareholder level. Therefore, a C corporation’s income is subject to double taxation.
- An S corp election may lower your employment taxes. Reducing your overall employment tax liability is possible because you can be both the owner and an employee of your corporation. Shareholders can be employees of the business and can be paid salaries as employees. Employment taxes must be paid on the amounts received as salary. However, shareholders can also receive dividends from the corporation on which employment taxes are not paid. This is an advantage S corps have over sole proprietorships and partnerships as their owners are not considered employees.
- S corps may have reduced taxable gains. If you choose to sell your business, your S corp could have reduced taxable gains.
- S corps can write off startup losses. An S corp can write off many of the expenses and losses incurred during the early years of starting the business. These are offset against personal income. Shareholders in C corporations cannot use losses to offset profits.
- Cash method of accounting. S corporations can choose either the cash or accrual method of accounting unless they maintain inventory, in which case they must use the accrual method. C corporations generally cannot use the cash method.
6. What are the requirements for an S corp?
- Complexity is a key disadvantage. Corporations are more challenging and time-consuming for small businesses to set up and administer than doing business as a sole proprietorship or partnership. And because an S corp is a corporation, it must adhere to the strict filing and operational processes of a corporation. Incorporating can also be costly. To maintain compliance with tax and legal requirements, many business owners outsource to tax and legal professionals.
- Limit on number and citizenship of shareholders. S corporations may only have up to 100 shareholders, and each shareholder must be a U.S. citizen or resident alien.
- Calendar year. An S corporation must adopt a calendar year as its tax year unless it can establish a business purpose for having a fiscal year.
- One class of stock. An S corporation can only have one class of stock, which can impair the corporation's ability to raise capital. Non-voting stock is not considered a “separate class” for this purpose, however.
- Taxable fringe benefits. Most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2 percent of the corporation. This is a disadvantage of S corp taxation versus C corp taxation.
7. How do I form an S corp?
You don’t form an S corp or a C corp. You form a corporation. Incorporation documents, typically called the Articles of Incorporation or Certificate of Incorporation, must be filed with the appropriate state agency and the necessary state filing fees paid.
Once formed, if you want to be taxed as an S corp, you file IRS Form 2553 “Election as a Small Business Corporation” with the IRS.
8. Maintaining your corporate status under the state corporation law
An S corp must comply with the corporation law of its state of incorporation. And although state laws differ, in general, in order to maintain its good standing in the state it will have to continually maintain a registered agent, file annual reports, and pay franchise taxes.
It’s important to be aware of the due dates for annual (or biennial) reports. These vary by state. Some states connect due dates to the anniversary of the corporation’s formation and some have a fixed date.
Some states may require initial reports/statements to be filed and fees to be paid within the months following incorporation. Your online incorporation specialist or registered agent will let you know if your state has this requirement.
Other compliance responsibilities of the corporation laws include:
- Holding a shareholders’ meeting every year
- Keeping corporate minutes (in a corporate record book) and allowing shareholders to vote on major corporate decisions
- Adopting and maintaining bylaws
- Keeping a record of all stock transfers
- Keeping detailed financial records
- Qualifying (registering) in states other than its state of incorporation in which the corporation transacts intrastate business (foreign states) and maintaining a registered agent and filing annual reports in those foreign states.
An S corporation will also have other compliance obligations such as having to keep licenses and permits up to date — which all businesses must comply with whether incorporated or not.
9. Maintaining your tax status under Subchapter S of the Internal Revenue Code
An S election is effective until it is voluntarily terminated by the corporation, or it is revoked by the IRS.
In order to continue being taxed as an S corporation you must comply with the requirements of Subchapter S. If you add an ineligible shareholder, such as a citizen of a foreign country, or have more than 100 shareholders, or if you add a class of preferred stock, your corporation’s S election will be revoked by the IRS and the corporation will generally be prohibited from making a new election for five years.
It’s therefore important to be aware of the requirements to ensure you don’t unintentionally lose your S corporation tax status.
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