Choosing the right business structure is one of the most consequential decisions business owners face. The company’s structure has an impact on everything from taxes to liability.
An S corporation, or S corp, is one of several business structures you might choose, especially if you are seeking the benefits of a corporate structure without the taxes imposed on large businesses. Here’s a look at what an S corporation is and the details of how it works, so you can decide whether this structure is right for you.
Key Points
• An S corporation allows profits and losses to pass through to shareholders, avoiding corporate taxes.
• Shareholders pay federal income tax on S corporation profits at their individual rates.
• S corporation owners can pay lower self-employment taxes by designating some income as distributions.
• S corporations have more ownership restrictions than other business types.
• To be eligible for S corporation status, a domestic corporation may have no more than 100 shareholders.
S Corporation Definition and Structure
An S corporation is a type of business structure in which owners own shares of the business and a board of directors oversees the company’s operations. The S corp dispenses profits to shareholders through salaries or other distributions.
Importantly, S corps are “pass-through” business entities. This means that corporate income, losses, deductions, and credits are not taxed at the corporate level. Instead, they’re passed through to the shareholders, who pay federal income tax on it at individual rates on their Form 1040 returns.
S corps protect shareholders by limiting their liability if, say, a small business loan falls into default. Lenders can’t seize shareholders’ homes, bank accounts, or vehicles to satisfy corporate debts or legal judgments.
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How S Corps Differ from C Corporations
The benefits of S corps become especially apparent when they’re compared to other types of business entities, including C corporations. Profits of C corps are taxed twice: once at the corporate rate and again at the individual rate when stockholders declare their share of the remaining profits on their individual tax returns.
Pass-Through Tax Entity Explained
A pass-through tax entity like an S corp avoids the problem of double taxation because all profits are passed directly to the company’s shareholders. Other pass-through entities include sole proprietorships and partnerships. Limited liability companies can also choose to be taxed as pass-through entities.
S Corporation Tax Benefits
Overall, S corps offer several tax advantages that make them an appealing choice for small business owners.
Avoiding Double Taxation
As mentioned above, one big advantage afforded by S corp status is that you avoid the double taxation that C corps face. For all C corporations, profits are taxed first at the corporate rate of 21%. When the remaining profits are passed to shareholders, that money is taxed again at each shareholder’s individual income tax rate. Marginal rates for individuals top out at 37%.
Self-Employment Tax Savings
The federal government levies self-employment taxes to cover the cost of Social Security and Medicare. Self-employed individuals typically must pay 15.3% of their income toward these taxes.
You have more control of your tax bill with an S corp, meaning you could pay less if you classify some of your income as salary and some of it as profit distributions. You’ll have to pay self-employment taxes on the salary portion, but not on the distribution portion. In most cases you will still have to pay federal income taxes on both the salary and the distribution.
Pass-Through Deductions and Credits
The Tax Cuts and Jobs Act allows households with income from S corps to exclude up to 20% of their qualified business income from federal income tax. However, some types of income (such as capital gains and wages from other employment) aren’t eligible for this deduction, so you’ll probably want to consult a tax professional about your particular situation.
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S Corporation Eligibility Requirements
If you’re wondering how to incorporate your business, the place to start is with IRS eligibility requirements. According to the IRS’s S corporation definition, a business must meet the following criteria:
• It must be a domestic corporation.
• Only certain kinds of shareholders are allowable, including individuals, certain trusts, and estates. Partnerships, other corporations, and non-resident aliens may not be shareholders.
• The business cannot have more than 100 shareholders.
• It issues only one class of stock.
• The business cannot be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations.
How to Elect S Corporation Status
To elect S corp status, the business must submit Form 2553, “Election by a Small Business Corporation.” The form must be signed by all shareholders.
You may fill out and submit the form at any time during the year before the status is set to take effect. But if you want the status to take effect during the current year, the form must be filed within the first two months and 15 days of the tax year.
S Corporation vs Other Business Structures
How do you decide whether or not an S corp is appropriate for your business? First, consider how it differs from other business structures.
S Corp vs LLC Comparison
Like S corps, limited liability companies (LLCs) lessen your personal liability, as the name suggests. In both cases, your own assets are largely protected from the debts, obligations, legal penalties, and other liabilities of the business.
In general, LLCs tend to be relatively simple and adaptable compared to S corps, which have stricter requirements. As discussed above, S corps allow no more than 100 shareholders and may include only certain types of shareholders. LLCs, regulated by state statute, tend to have fewer ownership restrictions and often have simpler tax rules.
S Corp vs C Corp Differences
We’ve already covered some of the differences between S corps and C corps. Another important distinction is that C corps can issue multiple classes of stocks and have an unlimited number of shareholders. As a result, C corps are able to attract significant investor capital that they can use to purchase equipment, hire employees, and grow the business. The C corp is the standard structure for companies planning to sell shares on public stock markets.
S Corp vs Partnership Structure
A partnership is a simple structure for two or more people who own a business together. Partnerships are pass-through structures, like S corps, so profits are passed through and taxed at partners’ individual rates.
There are two common kinds of partnerships: limited partnerships and limited liability partnerships (LLPs). In a limited partnership, one partner will generally have unlimited liability, while the others’ liability will be limited. Partners with limited liability often have limited control in the company. LLPs are similar, but provide limited liability to all partners.
S Corporation Disadvantages and Limitations
S corps present several potential disadvantages.
For one, they are more complex to administer than other structures such as sole proprietorships or partnerships. Corporations require more extensive record-keeping, operational processes, and financial reporting.
S corps only allow you to issue a single stock class. As a result, all investors receive the same amount in dividends or other distributions. This can be a disadvantage if you’re trying to attract other types of shareholders. What’s more, this rule allows for less flexibility in allocating income or losses to specific shareholders.
There can be no more than 100 shareholders total, which can limit the company’s ability to raise funds by selling shares. Foreign ownership is prohibited entirely.
Because of their complexity compared to sole proprietorships and partnerships, and because of the unique advantages they offer, they may be subject to greater IRS scrutiny than other types of structures.
Finally, not all states recognize the federal S corp designation. If they don’t, they may tax the business as a C corp, or they may have their own rules for S corps. Check the law in the states where your business operates to understand how S corps work there.
The Takeaway
An S corp is a business structure that can provide you with tax advantages, liability protection, and flexibility. It isn’t right for everyone, though. Understanding the requirements, procedures, and limitations can help you decide whether an S corp election supports your business goals.
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FAQ
How does an S corporation differ from a C corporation?
S corps are structures that are typically more appropriate for smaller businesses. They only allow 100 shareholders maximum, one class of shares, and they offer pass-through tax advantages. C corps are what most large corporations are. They allow for unlimited shareholders, which can help businesses raise capital by selling shares. And C corp profits are taxed twice: once at the corporate level and then again when they are distributed.
What are the requirements to qualify as an S corporation?
The IRS requires your company to be structured as a domestic C corporation and limits the number of corporate shareholders to no more than 100 individuals (or certain trusts and estates). Only one class of stock may be issued.
What are the tax benefits of an S corporation?
S corps allow profits to pass through to shareholders where they are taxed at the shareholder’s personal income tax rates.
Can an LLC elect to be taxed as an S corporation?
Yes, LLCs can elect to be taxed as S corps.
What are the disadvantages of forming an S corporation?
S corps have several potential downsides. They can be complex to administer and may have less flexibility in distributing income. The number of shareholders cannot exceed 100, potentially limiting the company’s ability to raise capital by selling shares. S corps may be subject to special IRS scrutiny, and some states tax S corps as if they were C corps.
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