The Hustler's Digest StaffAn S company is a standard corporate structure with up to 100 owners or shareholders, all of whom must be US citizens. Learn more about the definition and requirements for forming an S corporation here.
Unlike partnerships and sole proprietorships, which hold the owners personally liable for the business’s expenses and payables, S corporations’ owners aren’t personally responsible if the firm can’t meet its bills. Thus, creditors won’t seize personal assets if the company can’t pay its debts.
What is an S corporation (S subchapter)?
An S corporation, often known as an S subchapter, is a type of corporation that complies with specified IRS regulations. If it does, it can avoid paying federal corporate taxes by passing income (along with various credits, deductions, and losses) directly to shareholders. S corp status, which is most commonly associated with small firms (100 or fewer shareholders), effectively gives a business the benefits of incorporation while also enjoying the tax-exempt benefits of a partnership.
How to Establish an S Corporation?
- Choose a Unique Business Name
Select a unique name for your S corporation that is not already in use within your jurisdiction. Check with local state or town offices to ensure your chosen name is available. - Form a Board of Directors
Assemble a board of directors to govern on behalf of the shareholders. This board must meet regularly, keep meeting minutes, and create management policies. Every S corporation needs a board, which can issue common or preferred stock. - File Articles of Incorporation
Submit articles of incorporation to both the IRS and the local Secretary of State’s office. This may include a document outlining the business’s purpose. Requirements vary by state but generally include:- Names and contact information of the management team and board of directors.
- Name of the S corporation.
- Amount of shares issued.
- Share allocation details.
- Registered agent name.
- File Corporate Bylaws
File the corporate bylaws with the local Secretary of State office. Bylaws typically include:- Procedures for electing and removing directors.
- Methods for selling shares of stock.
- Guidelines for holding meetings.
- Voting rights.
- Processes for handling the death of a director or officer.
- Submit IRS Form 2553
Once you receive the certificate of incorporation, file Form 2553 with the IRS to register the corporation. This form, Election by a Small Business Corporation, confirms your S corporation status. - Hire a Registered Agent
Many states require your S corporation to have a registered agent. This agent receives all legal documents and correspondence from state and federal agencies.
By following these steps, you can successfully form an S corporation.
S corporation vs limited liability company
Limited liability companies (LLCs) and S corporations are comparable company forms. In theory, neither of them pays any taxes. Instead, their net taxable income is taxed on the personal tax returns of the company’s shareholders. And because they are independent legal companies, the owners are insulated from liability, and their assets are safeguarded.
S corporations and limited liability companies differ in the following ways:
- LLCs can have an unlimited number of members: an LLC can be a single-member LLC or a multi-member LLC with total shareholders, but an S corp is capped at 100 shareholders.
- LLCs can have nonresident alien shareholders: S corps are not permitted to have non-US citizens as shareholders.
- LLCs can be owned by corporations, partnerships, trusts, or other LLCs.
What are the advantages of an S corporation?
Here are some of the most commonly mentioned benefits that an S corporation can provide to its shareholders. However, you should be clear on your short- and long-term objectives, as an advantage can become an S corp disadvantage in some situations.
Pass-through taxation, for example, is generally beneficial because it reduces tax. However, if a company’s purpose is to save money for expansion—say, to build a new facility—a C corporation may be the preferable option because profits can be kept within the company.
Asset protection
One of the most significant benefits of an S corporation is that it offers limited liability protection to its owners regardless of its tax status. Limited liability protection protects the owners’ assets from business creditors’ claims, whether based on contracts or litigation. In truth, all businesses and limited liability companies (LLCs) offer limited liability protection.
Pass-through taxation
Business income and many tax deductions, credits, and losses are passed through to the owners rather than being taxed at the corporate level, which is a tax benefit for S corporations. This eliminates the risk of “double taxation,” which arises when dividend income is taxed first at the corporate level and subsequently at the shareholder level in C businesses.
An S corporation is a pass-through entity for federal (and most state) income tax purposes. A limited liability company (LLC) is also a pass-through tax entity. It should be noted that it can decide to be taxed as a C corporation if the business owners believe it is in the company’s best interests.
Salary and dividend payments
The owner of an S corporation has the option of receiving both salary and dividend payments from the company. This may result in a lower overall tax bill.
Why? This is because dividends are exempt from self-employment tax. Furthermore, when calculating the amount of income passed through to the shareholders, the S corporation can deduct the cost of the wages paid.
The division between wages and dividends, on the other hand, must be “fair” in the eyes of the IRS. (The IRS keeps a close eye on these kinds of transactions and may intervene to reclassify the income if it believes the payments were excessive.)
Ease of conversion
All that is necessary of S corporation shareholders who wish to be taxed as a C corporation is to file this election with the IRS. An LLC that is now taxed as a pass-through entity but wishes to be treated as a C corporation can submit a form to the IRS. If LLC owners want to convert their LLC to a C or S corporation, they must follow state corporation and LLC statutes and file documentation with the state. Dissolution/withdrawal filings, formation filings, and other types of filings are among them.
What are the disadvantages of an S corporation?
As previously said, some advantages can work against specific types of organizations and company plans. Here are some of the drawbacks of being an S company and some of the complications that come with doing business as a corporation rather than a more flexible LLC.
Strict qualification requirements
To be qualified to make an S corporation election — and to remain an S corporation — the company must meet specific standards regarding the number and kind of shareholders, as well as the types of shares. The federal tax code, not state corporate law, dictates these requirements. These rules are, in a nutshell, as follows:
- Only individuals, certain estates and trusts, and specific tax-exempt organizations can be shareholders
- There cannot be more than 100 shareholders (although some family members can be counted as a single shareholder)
- There can only be one class of stock (although differences in voting rights are permitted)
These limits do not apply to an LLC that is a pass-through entity. Although both an S corporation and an LLC are pass-through companies, their taxation is not the same since they are taxed under separate provisions of the Internal Revenue Code.
Rigid profit and loss allocation
An S corporation is mandated to distribute profits and losses to its shareholders based only on the percentage of ownership or number of shares owned. On the other hand, An LLC can distribute profits and losses in whatever proportions the owners wish.
As a result, a founding member who transfers 50% of the LLC’s ownership to a new member may obtain a disproportionate amount of the LLC’s profits. The founders’ share of an S corporation has decreased from 100 percent to 50 percent.
Corporate formalities
Remember that an S company is, first and foremost, a business. This implies it must follow all of the corporate formalities set by the company statute of its native state. On the other hand, State LLC laws impose significantly fewer statutory procedures. In the LLC Handbook, you may learn more about limited liability companies.
Corporations and limited liability companies (LLCs) must register in states other than their home state.
Alternatives to consider
S-corporations are just viable business structure classifications, although having many attractive attributes. As with any business decision, the best option is determined by the details of the situation. Here are a few more popular alternatives:
C-Corp
C-corporations are the most popular type of corporation—essentially the default option—and, like S-corporations, they acquire their name from the Internal Revenue Code subchapter in which they are classified. While state-corporate rules usually do not distinguish between S-corps and C-corps, there are significant distinctions in federal taxation.
A C-corp pays corporate income tax first, along with a federal return (Form 1120) that the IRS requires. After that, any dividend gains must be taxed as personal income at the individual level by shareholders. C-corps benefit from the lack of constraints on owning shares in exchange for the less favorable double taxation. C-corporations, unlike S-corporations, can have an unlimited number of stockholders and include domestic and international enterprises and institutions.
LLC
A limited liability company (LLC) combines relative ease and flexibility with higher risk protection and tax benefits. Owners of LLCs (also known as “members”) are not individually accountable for their company’s obligations. Members, by default, pay taxes in the same way that sole proprietors or general partners do. However, if an LLC meets specific criteria, it can be taxed as an S-corporation or a C-corporation. Instead of incorporating as a corporation, many small business owners pick LLCs for simplicity and flexibility and then elect S-corp status.
Rather than filing Articles of Incorporation like a corporation, LLC founders must file Articles of Organization with the state department that oversees business registration. An LLC, like a corporation, must have a registered agent.
General rules for taxation of S corporation distributions
The rules distinguish between distributions made by an S corporation without accumulated E&P and distributions made by an S corporation with accumulated E&P. As a result, the first step in evaluating whether S corporation dividends are taxable is to determine whether the S corporation has accrued E&P in the year of distribution.
An S corporation can only own accumulated E&P if it was previously a C corporation or bought the assets of a C corporation in a Sec. 381 transaction, as previously stated. So, if an S corporation has never been a C corporation (i.e., it has been an S corporation since its establishment) and has never purchased the assets of a C corporation in a Sec. 381 transaction, it cannot have E&P.
It’s crucial to figure out whether the S firm has amassed E&P. If an S business does not have any accumulated E&P, determining the taxability of a distribution is a simple process. However, if an S corporation has accumulated E&P at the time of distribution, evaluating the taxability of that dividend is more complicated.
Most successful S corporations
Because there are so many ways to assess a company’s performance, we’ve compiled a list of the most successful businesses in the United States based on five distinct indicators.
By sales
Walmart (WMT) pulled in $562.8 billion in the last year, more than any other firm in the S& P 500.
By profits
Apple (AAPL), the world’s most valuable firm, has made $76.3 billion in net income in the last 12 months, more than any other company in the S& P 500.
By shareholder returns
Marathon Oil (MRO), an oil and gas producer, has a 1-year trailing return of 158 percent, which is more than any other S&P 500 business.
By employee satisfaction
In Fortune Magazine’s “100 Best Companies To Work For” survey for 2020, Hilton Worldwide Holdings (HLT) was named the best place to work.
The study, conducted by analytics firm Great Place to Work, included more than 60 questions about their workplace and was completed by 4.1 million employees.
By carbon footprint
Apple has the lowest ratio of greenhouse gas emissions to revenue of any S& P 500 corporation. Apple produces 120.5 tonnes of carbon dioxide for every million dollars in revenue.
This comprises the company’s direct and indirect emissions from energy use and all emissions upstream and downstream from the company, such as raw materials, goods transportation, and product disposal costs.
Why would you choose an S corporation?
An S company provides limited liability protection, preventing creditors from seizing personal assets to pay off corporate debts. S companies can also assist owners to save money on corporate taxes by allowing them to report revenue transmitted through the business to them and taxed at their rate.
If numerous people were involved in running the company, an S Corp would be preferable to an LLC because the board of directors would provide oversight. Members can also be employees, and an S corporation permits members to receive cash dividends from the company’s revenues, which can be a terrific bonus for employees.
How to convert an LLC into a corporation taxed as an S corp.?
Step 1: If your state permits, convert your LLC to a corporation. For further information, contact your state’s business section.
Step 2: Complete all corporation criteria.
Step 3: Change your business entity (as filed with the IRS) from an LLC to a corporation by filling out IRS Form 8832. This form can be filed with a 75-day backdate or a 12-month future date.
Step 4: As described above, file IRS Form 2553 to elect S corp. status for your newly created corporation.
When to elect S corp. status for your LLC?
According to experts, if a corporation can pay its owners “fair salaries” and at least $10,000 in distributions per tax year, a multi-member LLC should adopt the S corp classification.
Note: Most small businesses don’t produce enough money in the early stages to justify electing S corporation status.
Choose S corp. status if:
- You’re a seasoned businessperson who knows how much money you make each year.
- You’re already familiar with the responsibilities that come with S Corp statuses, such as bookkeeping and payroll.
- Even after paying the “fair compensation,” your company earns enough to save money with S corp classification.
Choose Default tax status if:
- You’re a new entrepreneur with no idea how much money you’ll make each year.
- You don’t want to deal with administrative tasks like bookkeeping and payroll.
- Your company isn’t profitable enough to save money as an S corporation.
LLC to S corp. tax consequences
The majority of small business owners reinvest their profits to expand their company and produce enough profit to cover the increased expenditures of operating as an S corporation (or to pay a reasonable salary in addition to enough distribution to lead to actual tax savings).
Default LLC tax structure
The LLC’s profit, after expenses, is taxed on the owner’s (s) personal tax return in the default tax structure. The money is subsequently taxed as self-employment income by the owner.
If the LLC has more than one member, each owner’s part of the earnings is taxed on their tax return.
S corp. election
You must pay yourself a reasonable income if you are an “active shareholder” under the S corp classification – that is, if you have an active involvement in business activities.
To make the S corp financially viable, you must pay yourself at least $10,000 in distributions.
By not paying FICA taxes on distributions, S corp owners can save around 16 percent on self-employment taxes in the right conditions.
Business owners pay both FICA and income taxes on their salary, but any distributions (or draws) are only subject to income taxes.
FAQs
Who pays more taxes, an LLC or S corp.?
It is dependent on how the firm is set up for tax purposes and how much profit will be made. An LLC and an S corporation can be taxed at the individual level. Although LLCs are frequently taxed at personal rates, some LLC owners choose to be treated as a separate business with their federal identification number. Owners of S corporations must be paid a salary in which they pay taxes.
Taxes on Social Security and Medicare. Dividend income or a portion of the leftover earnings (after the owner’s salary has been paid) can be passed through to the owner, but not as an employee, which means they will not be subject to Social Security and Medicare taxes.
Should I make my LLC an S corp.?
An LLC may be the ideal option if you’re a lone proprietor because your business and personal assets are segregated. You can always change the structure or form a new S corporation in the future. Because an S company has a board of directors, a limit of 100 shareholders, and more regulatory obligations, it is preferable for more complex organizations with more individuals involved.
The bottom line
The S election, known for its exemplary tax benefits, might not be the best choice for every business. If your company doesn’t generate enough income to meet the “reasonable compensation” criteria, it may not be suitable. Additionally, many businesses can’t qualify due to restrictions on stock classes, shareholders, domesticity, and operating regions. Before filing an IRS election, it’s crucial to debunk several myths about S corporations.
Remember, the S election affects your federal taxes. Since state taxes vary significantly, investigate how your state handles S corporations. Most states recognize the S election, aligning state tax treatment with federal standards. However, some states don’t recognize the S election for state-level taxes, while others impose franchise or excise taxes on S corporations.
By understanding these nuances, you can make an informed decision about whether the S election is right for your business.
