Previously in this blog series, we discussed sole proprietorships, partnerships, LLCs, and Corporations, and areas to consider when deciding on a business structure (read our first post in this series for more detail regarding these areas). In this post we'll be discussing S corporations.
What is an S Corporation?
A Subchapter S (S Corporation or S Corp.) is a form of corporation that meets specific Internal Revenue Code 1361 requirements, giving a corporation with 100 shareholders or less the benefit of incorporation while being a pass-through entity. S corporations pass income directly to shareholders and avoid double taxation on the dividends of corporations, while still enjoying the advantages of the corporate structure.
S corporations, like C Corporations, can be more complex than other business structures. They tend to have more costly administrative fees and complex tax and legal requirements. However, shareholders benefit from having limited liability and avoid double taxation that applies to regular corporations. Shareholders are limited to individuals, specific trusts, and estates, whereas shareholders of C Corporations may include other types of entities.
Areas to Consider:
There are different tax and legal advantages and disadvantages for each company type. The following areas help break down the different tax and legal differences between entity types.
As mentioned in our most recent post, corporations take more effort than other entity types to form and are considered costly and time-consuming ventures to start and operate. Filing as an S corporation, requires that you register as a corporation first. Below illustrates the steps involved in setting up a corporation.
- Establishing a Business Name: Requires more effort.
- Choose a business name. Note that either, "corporated", "incorporated", or "limited" is likely a requirement within the business name. However, state regulations vary.
- Register business name with your state government.
- Business registration: Requires more effort.
- Contact your state business entity registration office to determine registration specifics. List of Secretary of State websites compliments of The Balance
- Depending on your state you'll be required to file articles of incorporation or other registration documents.
- You may also be required to establish directors and issue stock certificates to initial shareholders.
- Obtain all necessary licenses and permits.
- Ongoing Administration: Requires more effort.
- There are reporting requirements, making corporations more complicated than other entity types.
- Talent Management: Potentially less effort.
- Corporations offer competitive benefits and the potential for partial ownership through stock options. This may enable them to attract and retain high-quality and motivated employees more easily than other entity types.
To file as an S corp., shareholders must sign and file Form 2553 (see Form 2553 Instructions) with the Internal Revenue Service within 75 days of starting a business. The following requirements must be met for a company to qualify for S corporation Status.
- It's a domestic company
- Shareholders meet requirements:
- Are: individuals, certain trusts, and estates
- Are not: partnerships, corporations, or non-residential aliens.
- Have no more than 100 shareholders
- Have only one class of stock.
- Are not an ineligible corporation such as an insurance company, domestic international sales corporation, or certain financial institutions.
It's important to note that the ability to file as an S corp. is also possible for some limited liability companies (LLCs).
With regards to tax, S corps resemble a hybrid of corporations and partnerships. Where corporations are taxed first at the corporate level and then again at the shareholder level, S corps resemble partnerships, their income, loss, credits, and deductions are passed through to the shareholders. This enables S corps to avoid double taxation which C corporations are subject to.
- Federal, State, & Local Taxes - These business structures are subject to certain tyoes of federal and state taxes such as franchise tax and depending on their locality, local taxes might also be applicable.
- Income tax - Likely None. Profits or losses are usually recorded on each of the shareholders' individual tax returns.
- Employees - Unlike partners within partnerships, shareholders are considered employees and are subject to employment tax and must receive a wage that reflects reasonable compensation.
Like corporations, subchapter S's are required to maintain a balance sheet and income statement and record corporate minutes annually. S corps must file annual corporate tax returns that the federal, state, and possible local level even though no tax may be due with these returns.
Control falls to the owners, shareholders (up to 100), or in some cases the board of directors. These entity types are privately owned so the owners/shareholders make all the decisions, although they may choose to elect a board of directors to aid in the direction of the company. Unlike sole proprietorships where there is always only one owner, control is split between multiple individuals requiring a more intensive processes for decision making. The bigger the company and the more shareholders, the less control an individual has over the company.
With the ability to sell stock, corporations have an easier time raising capital than other structures.
Shareholders personal assets are protected from the risk of business debts and lawsuits. Only through their investment in stock of the company are shareholders generally held accountable.
- S corporations are independent legal entities.
- Owners are referred to as shareholders.
- Forming an S corp tends to be more costly, time consuming and complex than other entities.
- Retaining higher-quality employees may be easier due to the available benefits.
- In MOST cases S corps DO NOT result in double taxation.
- Annual financial statements and recorded minutes are required.
- Control levels can vary.
- This structure is usually recommended for more complex companies.
- Funding is gained through the sale of stock.
- Limited liability