What is an S Corporation (S Corp)?
An S corporation, often known as an S corporation, allows its shareholders to receive all taxable revenue, credits, deductions, and losses straight from the tax law. Because of this, it has several benefits over the more typical C company. The S corp is an alternative to the limited liability corporation (LLC) and is only accessible to small firms with 100 or fewer stockholders.
S corporations and LLCs are called “pass-through entities” due to their non-payment of corporate taxes. Instead, they settle the outstanding taxes with their stockholders.
S companies got their name by knowing S Corporation (S Corp) Subchapter S of the Internal Revenue Code, which specifies how they choose to be taxed. An entity that files under Subchapter S is called a pass-through entity because it can transfer business income, losses, deductions, and credits to shareholders directly without paying any federal corporate tax. This entitles it to some unique tax advantages under the Tax Cuts and Jobs Act of 2017. On the other hand, it is subject to corporation taxation on certain capitalized gains and passive income.
Except for its tax classification, an S corporation is officially called a C corporation, like any other company. State corporation laws established it as a for-profit company. It provides a C company with the same ownership, management, and liability protection benefits.
It must also adhere to internal procedures and guidelines, such as:
Having a board of directors that drafts corporate bylaws, holds shareholder meetings, and keeps minutes of important business sessions.
An S corporation and a C company vary primarily in how they are taxed. There is double taxation when a C corporation makes profits and then pays dividends to shareholders. A S company may distribute income to shareholders directly without paying federal corporation taxes.
Understanding an S Corporation (S Corp)
An organization must fulfill specific Internal Revenue Service (IRS) standards to be eligible for S corporation status. It must only have one class of stock, be domestically formed (inside the United States), and have no more than 100 stockholders. These shareholders also have to be eligible, which means they have to be persons, certain types of trusts and estates, or certain kinds of tax-exempt organizations [501(c)(3)]. Corporations, partnerships, and nonresident aliens are not permitted to be eligible shareholders.
S Corp. shareholders pay taxes at their regular income tax rates and record income, profits, and losses from the business on their tax returns. They avoid paying taxes twice on any revenue or gains from the firm since the money is given to them without incurring corporate tax.
How to Form an S Corporation
A company must first be formed to become an S corporation.
After that, it has to send Form 2553 to the IRS. According to the form, the IRS will only accept S corp status if the company satisfies all requirements, officially known as election by a small business corporation. It also requires that “all shareholders have signed the consent statement, an officer has signed below, and the exact name and address of the corporation (entity) and other required form information have been provided.”
Benefits and Drawbacks of S Corporations
Benefits of S Corp. Registration: Tax savings for corporations. The advantage of registering as an S corp to businesses is avoiding entity-level federal taxation.
It is advantageous to save money on company taxes, particularly in the early stages of a firm.
Savings on personal income taxes. Having an S corporation may also reduce the company’s income tax liability. S corporation owners often reduce their self-employment tax obligation by classifying funds they receive from the firm as dividends or salaries.
The S corporation classification generates deductions for company costs and employee pay.
S corp. owners may also benefit from pass-through entity tax advantages.
Corporations pay dividends. As long as the distribution does not exceed their stock basis, S Corp. stockholders can work for the firm, receive tax-free corporate dividends, and receive pay. Dividends over a shareholder’s stock basis are subject to capital gains tax levied at a rate lower than regular income.
Transfers of assets became more straightforward. Other benefits include changing property bases or transferring interests without worrying about complicated accounting regulations or unfavorable tax repercussions.
Aid in building trustworthiness. Being an S corporation demonstrates the owner’s official dedication to the business, which may assist in building credibility with prospective clients, workers, suppliers, and investors.
The Drawbacks of Forming a S Corp
IRS examination. Because S companies might pass off wages as corporate distributions to avoid paying payroll taxes, the IRS closely monitors how S corporations pay their staff. Before making any distributions, a S company must pay shareholder-employees a fair salary for the services they have provided.
We have limited distribution guidelines. The S Corp. must strictly divide income and losses among stakeholders according to the percentage of ownership or number of shares each person holds.
Subject to IRS approval and status removal. The IRS may sometimes revoke an S corporation’s Subchapter S status if the S corporationoration fails to distribute earnings and losses correctly or engages in other noncompliance actions, such as errors in an election, consent, notice, stock ownership, or filing requirement. On the other hand, noncompliance mistakes may often be quickly corrected to prevent adverse outcomes.
It costs money and requires time. The process of establishing an S corporation costs money and takes time. The articles of incorporation must be filed with the secretary of state in the state where the owner of the company headquarters the firm. The corporation has to pay additional expenses related to incorporation and establish a registered agent for the company.
Charges. Owners must pay a franchise tax, yearly report fees, and other various taxes in numerous states. Nonetheless, the fees are usually negligible and may be written off as an operating expense.
In addition, all investors enjoy dividend and distribution rights regardless of their voting rights.
Growth constraints. The restrictions on the quantity and kind of shareholders may be burdensome for a company that is expanding quickly and is trying to draw in institutional or venture capital funding.
Positives: no double taxation for shareholders, little corporate and self-employment taxes for owners
Protections of incorporation: transfer of interests and restricted liability
Credibility and prestige
Cons: Incorporation costs
- intricate regulations for compliance
- potentially inhibitive growth requirements to retain the status
- LLC v. S Corp
Another kind of legal corporate organization is a limited liability corporation (LLC). It is a typical small company go-to structure, much like S Corp.
S corps and LLCs also have several additional traits in common. Both offer limited liability protection for their owners or principals, which means that the owner’s assets are shielded from business creditors and cannot be held personally liable in lawsuits brought against the company. Both are pass-through entities, meaning they do not pay corporate taxes.
Like S corp owners, LLC owners profit tax-wise from the Tax Cuts and Jobs Act as a pass-through business.
S corporations are less versatile than LLCs, nevertheless. Any federal or state legislation about governance, process, or the distribution of money does not bind them. They are not subject to IRS requirements governing the quantity and kind of shareholders and owners (“members”). They can divide their gains and losses in whatever ratio the owners want.
Take note
LLCs are usually founded by solo owners or small groups of professionals, such as physicians, accountants, or lawyers since they are easier to set up than S corporations. Nevertheless, compared to equity investors, their financing choices are more constrained and often only include bank loans. This may restrict their ability to advance.
S Corporation Income Tax Return for the United States
Still, firms must submit tax returns and declare their revenues to the federal government, even if they are mostly free from corporate taxes.
An S corporation’s tax return is mainly included in Form 1120-S. Form 1120-S, often filed with Schedule K-1, which lists each shareholder’s percentage ownership of the company’s shares, provides information on the corporation’s profits, losses, dividends, and other payments to its shareholders.
“Form 1120-S, U.S. Income Tax Return for a S Corporation,” from the Internal Revenue Service
Like individual taxpayers, S corps are required to file just once a year, while C corps must file regularly. Additionally, Form 1120-S is more uncomplicated than C company tax filings. The 2022 edition included five pages.
A firm must submit Form 1120-S if it chooses to become an S corporation, and the IRS has recognized that choice. The form must be submitted by the fifteenth day of the third month after the conclusion of the fiscal year, which falls on March 15 for businesses that use a calendar year.
S companies have the same six-month extension period as individuals to submit their tax filings. To do this, they must submit their return by the customary deadline using Form 7004: Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns.
What Makes a S Corporation (S Corp) Your Best Option?
S companies combine the tax advantages of partnerships with the advantages of corporations. They provide the corporate structure’s limited liability protection, which keeps an owner’s assets safe from creditors or lawsuits brought against the corporation. However, they do not have to pay corporation taxes on any profits or income they make, just as partnerships do. Additionally, they may aid owners in avoiding self-employment taxes.
How is the S Corps operational?
An S Corp. functions just like any other company. It creates a management structure, rules, a board of directors, and corporate officials under the corporation legislation of its native state. It distributes equity in the firm. Its owners are immune from financial or personal liability for claims made by creditors or against the business.
What distinguishes a C Corporation (C Corp) from a S Corp?
Corporations pay income taxes on their profits, just as individual taxpayers do. (At the moment, companies in the U.S. pay a flat 21% tax.)
Following taxes, any dividends or other gains are given to the shareholders. On the other hand, S companies may provide investors with higher returns since they are often free from federal tax on most of their earnings. S corporations are subject to certain IRS-mandated limitations in exchange for this tax advantage.
The Bottom Line: Small firms are often advised to use S corporations as a legal structure. They provide corporations with restricted liability protections and the tax benefits of partnerships. Compared to typical C companies, they are easier to form and manage, resembling a “corporate lite” structure.
Starting with the fees and processes involved in formation, S Corps is subject to many of the same regulations and expenses as ordinary companies. They are unquestionably more costly to set up and require more work to manage than LLCs, another common form for small businesses.
While this is good for companies that are expanding quickly, the IRS has constraints on the size of these companies and the number of stockholders they may have, which may ultimately prevent them from growing further. The good news is that, should the circumstances warrant it, converting an S company to a C corporation is relatively easy.
Conclusion
- One legal corporate structure popular among small businesses is the S corporation, or S subchapter. Another is a limited liability corporation (LLC).
- A company with 100 shareholders or less might profit from incorporation while paying partnership taxes thanks to S corp requirements.
- S corporations and LLCs provide limited liability protection for their owners and principals and are both pass-through businesses, which means they do not pay corporate taxes. LLCs are more adaptable, however.
- Individuals, certain trusts and estates, or specific tax-exempt organizations must be S company stockholders.
- The Internal Revenue Service (IRS) regulations controlling the quantity and kind of members—usually lone owners or small groups of professionals—do not apply to LLCs.
