What is An S Corporation? How to Form One

What is An S Corporation? How to Form One

 

What is an S corporation?

S Corporations pay fewer taxes than other types of corporations because they are formed to reduce tax. Shareholders can do this by filing their taxes using the company’s income and losses. An S corporation must file with the IRS as such, but not all businesses qualify and those that do must follow certain rules.

An S corporation is one that elects to pass its corporate earnings, losses, deductions, and credits to its shareholders for the purpose of federal taxation. According to the individual income tax rate applied to shareholders, taxes are calculated on flow-through income and losses of S corporations. By doing so, S corporations can avoid double taxation on their corporate income.

Advantages of S Corporation

From tax advantages to flexibility, forming an S corporation has many advantages. When it’s time to transfer ownership or discontinue the business, the S corporation structure can be particularly beneficial. However, sole proprietorships and general partnerships don’t have these advantages.  Additional benefits of an S corporation include:

  • Protected assets. Typically, owners of S corporations are not liable for their businesses’ debts or liabilities, and their personal assets are protected. 
  • Pass-through taxation.  It is the shareholders who report any business income or loss on their personal tax returns. As a result, business losses may be deducted from shareholders’ tax returns to reduce their income tax liability. This can be extremely helpful when starting a new business
  • Income that is tax-favorable. Corporation shareholders can work for the business and receive salaries as employees. S corporations often offer self-employment tax savings since the owners are treated as employees by the IRS. 
  • Ownership is easily transferred. Ownership can be transferred by selling stock.
  • Life is unlimited. An S corporation does not cease to exist when its owner suffers a disabling illness or dies. 
  • Raising capital is easier. Shares can be sold to raise capital.
  • Heightened credibility. Compared to sole proprietorships or general partnerships, S corporations may be perceived as being more professional and legitimate. Find out more about sole proprietorship vs. S corporation.
  • Audit risk is reduced. Corporations are generally audited less often than sole proprietorships.

What are the requirements for an S corporation?

In order to qualify for S corporation status, the corporation must meet the following requirements:

  • Corporations must be domestic
  • The maximum number of shareholders is 100.
  • A shareholder may be an individual, a trust, or an estate
  • Partnerships, corporations, and non-resident aliens are not permitted
  • Have only one class of stock
  • All members of the business must receive the same amount of distributions since the business can only issue one class of stock.

For a corporation to become an S corporation, it must submit Form 2553 Election by a Small Business Corporation, signed by all shareholders.

How to Start an S Corporation?

An S corp can be formed in two ways:

An S corporation (S corp) can be formed by forming a limited liability company (LLC) or a corporation and electing S corporation status when applying for your Employer Identification Number (EIN).

In my opinion, you should not start a corporation with the S corp tax status, since the S corp nullifies all of the benefits of a corporation.

The Internal Revenue Service (IRS) classifies S corporations as tax entities, not as business structures. In certain circumstances, the S corp status is used to reduce a business’s tax burden.

1. File your articles of incorporation

The first step you must take is to fill out and file a form for articles of incorporation, also called a certificate of incorporation, with your secretary of state’s office. This form provides basic information about your business, such as its name, address, purpose, and incorporators.

2. File as an S-corp with the IRS

Once your state has accepted your forms and approved the name of your business, you need to complete and submit Form 2553, Election by a Small Business Corporation. For your S-corp application, you will need to fill out the form, which you can find on the IRS website or at your local IRS office. Before you submit the form to the IRS, you must have each shareholder sign it.

How Does an S Corporation Work?

In many ways, an S corp works like any other corporation. Under the laws of its home state, it has a board of directors and corporate officers, by-laws, and a management structure. Shares of the company are issued. A company’s owners cannot be held financially responsible or personally liable for claims made against the company or by creditors.

Costs and Drawbacks of an S Corporation

Some small businesses may face extra costs and other disadvantages when incorporating as an S corporation. Establishing your business as an S corporation should be thoroughly researched prior to implementation, as it does have a substantial number of disadvantages and costs. The three main drawbacks to forming an S corporation are:

1. Excise taxes and state fees for corporations

Maintaining and forming an S corporation will cost money. An annual filing fee may be charged, as well as excise taxes and/or franchise taxes.

2. Additional tax return preparation costs

For state and federal tax returns, a tax accountant will need to be hired. Obtaining the data required to file income tax returns will most likely require the purchase of a modern computer accounting system. The company will also need to set up a department to issue and track employee paychecks.

3. Miscellaneous operating costs

Unexpected costs relating to insurance and accounting tasks may arise. The formation of an LLC or corporation may result in financial statements and additional insurance costs for your business. Moreover, some states may require you to have your financial statements audited by a CPA.

When Should A Business Become An S Corporation?

A small business can save on taxes by electing the S corp tax status if the following factors are met:

  • The business meets S corp restrictions
  • There is enough net profit in the business to pay a reasonable salary
  • Accounting and payroll costs do not outweigh the tax advantages

Start Your S Corp Today!

With Wise, you can form an S Corporation in just three easy steps. Discover the different packages and tools we offer to help you form an S Corp, stay compliant, and fulfill additional state and federal requirements.

Tags: Costs and Drawbacks of an S Corporation, How Does an S Corporation Work, How to start an S corporation, What are the requirements for an S corporation, What is an S corporation, When Should A Business Become An S Corporation
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