Fact checked for accuracy by Janet Berry-Johnson, CPA.
If you’re a business owner looking for limited liability protection, you might want to consider an S Corporation or Subchapter S Corporation.
Some organizations are eligible for this special tax structure, which exempts them from paying corporate income taxes. To qualify for an S Corporation, a company must meet specific qualifications.
But how do you meet those qualifications? What are the advantages of forming an S Corp? And what is an S Corp, anyway?
Here’s what you need to know.
What Is an S Corp?
An S Corporation, otherwise called “Subchapter S Corporation” or “Small Business Corporation,” is a special tax structure from the Internal Revenue Service (IRS) which permits exemptions from corporate income, losses, deductions, and credits directly to shareholders.
S Corp is generally associated with smaller businesses with fewer than 100 shareholders.
To obtain an S Corp, certain requirements must be met, including:
- Have 100 or fewer shareholders
- Domestically incorporated
- Possessing solely one class of stock
- Obtaining shareholders who fulfill specific eligibility demands
Companies with an S Corp typically don’t pay federal taxes. Instead, each of the business’s shareholders divides the income between them and records it on their personal income tax returns.
Obtaining the status of an S Corp allows companies to avoid double taxation on income earnings or being taxed both at the business owner level and corporate level. Wherever the business owner’s personal income amount resides on the tax bracket is the S Corp tax rate.
It’s important to remember that “S corporation” is a tax classification, not a business entity type like many mistakenly believe. Incorporating an S Corp isn’t possible. To obtain one, the IRS requires you to apply.
Benefits of Forming an S Corp
In this section, we’ll go over the advantages of forming an S Corp.
First, an S Corp ensures the protection of shareholder’s assets. Shareholders do not have individual responsibility for the corporation’s debts and liabilities.
Creditors may not pay business debts by pursuing personal assets—such as bank accounts or the house—of the shareholders.
Tax-Favorable Characterization of Income
Shareholders within an S Corp may be considered business employees, meaning they make salaries as employees. The corporation may also divide shares amongst shareholders and offer similar tax-free distributions.
Sensibly characterizing distributions as dividends or salary can help the business owner reduce self-employment tax liability while still producing wage and expense deductions for the corporation.
Typically, businesses with an S Corp are not legally required to pay federal taxes at the corporate standard. Most states follow these rules, but not all. It’s wise to stay up to date with the ongoing corporation requirements to check up on your state’s status regarding the federal S Corp polls.
Any generated losses or income ultimately passes through to shareholders, who then record the information on their personal income tax returns accordingly.
S Corp businesses record their losses, which can balance out other income reported on shareholders’ tax returns. Doing so reduces the amount of income tax paid, which can be very helpful when launching a business.
On the other hand, a C corporation that does not obtain an S Corp risks being categorized as a personal holding company.
Read our article on how a corporation is taxed to learn more.
Direct Transfer of Ownership
In an S Corp, interests may freely be moved without charging burdensome tax results. However, in an LLC (which we’ll touch on later), moving interest more than a 50-percent can activate the entity’s closing.
When an ownership interest is moved, businesses in an S Corp do not have to adjust property basis or adhere to extensive, complex accounting regulations.
Accounting Cash Method
Unless a business is a small corporation, company’s must use the accrual method of accounting. S corporations, on the other hand, use the cash method of accounting.
Using the cash method of accounting means keeping an account of recorded revenue whenever the business receives cash and expenses when the business makes cash payments.
If you become an S Corp, you can expect your business to establish heightened credibility with potential partners, vendors, employees, and customers because they see the official commitment the owners made to their company.
What You Need to Know About S Corp Tax Returns
If you obtained an S Corp status for your company, the IRS expects you to file Form 1120S, which serves as your business’s annual tax return. Below, we’ve explained what the 1120S is and how to file one for your business.
What is an 1120S?
Both companies and individuals alike must file a federal tax return each year.
To be an S Corp, the IRS requires businesses to fill out Form 1120S to record the deductions, credits, income, losses, gains, etc., from the company or business entity throughout the current tax year.
If your company has an S Corp tax categorization status, you have to file Form 1120S. If you’re unfamiliar with what that is, please visit the IRS’s website to learn more.
How Do I Fill Out My 1120S?
To properly file your Form 1120S, you’ll first need details on your business’s total sales before tax deductions, business expenses, profits, and any estimated taxes you owe.
There’s some other information you’ll want to obtain, as well, but overall, it’s wise to keep a record of your finances through the year to make the process easier.
Then, collect all the pertinent documents on the financial aspects of your business to fill out Form 1120S.
Who an S Corp Might Not Be a Good Fit For
An S Corp isn’t for everyone, and only some businesses qualify to receive an S Corp. Failure to meet any of the IRS’s specifications for their S Corp status at any point, the IRS can immediately render it invalid and automatically designate you as a C corporation.
Such a case could cause numerous problems when it comes time to file your taxes.
Upon examining the requirements for an S Corp and deciding your company cannot meet those requirements (the company has over 100 shareholders, non-U.S. citizen members, has more than one class of stock, etc.), an S Corp status might not be right for your business.
Additionally, if the IRS presumes a member has given a false account of their wages to reduce their tax payment, they may assign additional corporate earnings to a different category as wages, which could cause the shareholder’s tax load to considerably increase.
Differences Between an S Corp and C Corp
Below are three key differences between S Corps and C Corp.
The default category of a corporation is C Corporations. When you file your state incorporation articles, you’re automatically given a C Corp.
To become an S Corp, you must fill out Form 2553 (and occasionally a few others).
When it comes to ownership, C Corps does not have any restrictions and allow unlimited shareholders. An S Corp limits shareholders to 100 or less, and they must be U.S. citizens.
Partnerships and corporations cannot be S corp shareholders.
While S Corps have pass-through taxation, C Corps pay double taxation, meaning shareholders must pay federal income tax, and the company must pay corporate income tax.
S Corps requires shareholders to include business losses and income on their personal tax returns, meaning the only taxes they pay are included on their tax returns.
Differences Between an S Corp and LLC
Below are a few key differentiations between an S Corp and LLC. For more detail, read our comparison of an LLC vs. corporation.
Contrary to popular belief, an S Corp is not a business entity, whereas an LLC is. An S Corp is referred to as a chosen procedure of controlling how the business is taxed. A business with an S Corp avoids double taxation, as was touched on earlier in the article.
S Corp taxation is a matter of federal tax law, while an LLC depends on state law.
In an LLC, members must pay self-employment taxes directly to the IRS. According to the IRS, the 2020 tax rate for self-employment is precisely 2.9% for Medicare and 12.4% for Social Security.
Structure of Management
LLC management is more like that of a partnership, whereas S Corps typically have officers and directors.
While a group of directors monitors big decisions and official corporate procedures, LLCs do not generally require their members to be involved in regular business decisions. The directors then choose officers to organize day-to-day business functioning.
Stock, Shareholder Structure, and Subsidiary Restrictions
LLCs are not permitted to issue stock, while S Corps are, but only a single class.
According to the IRS limitations, S Corps must have less than 100 total shareholders, while an LLC may have an unrestricted number of shareholders.
Moreover, an S Corp only allows U.S. citizens as members, while an LLC allows anyone—U.S. citizens and non-U.S. citizens—to become shareholders.
S Corps and LLCs also have different subsidiary restrictions. While S Corps may not set up any subsidiaries, LLCs can set up subsidiaries with zero conditions.
The Last Word
Is an S corp right for your business? Ultimately, that’s up to you to decide. If you have any questions, feel free to drop us a line and we can help out or discuss it with your financial advisor. Also make sure to read our guide on how to form a corporation.
Filed under: Advice Columns