What is an S corporation?
An S corporation is a type of business structure that provides some of the benefits of being a corporation while potentially lowering the tax burden for its owners. S corporations have to follow certain rules to unlock all these benefits.
OK, so what’s a corporation?
Let's start at the beginning. A corporation is a type of business that adopts certain structures and procedures for making decisions and going about their business. Every type of corporation has:
- Shareholders – who own the business.
- Officers – who oversee day to day operations of the business (think chief executive officer, chief financial officer, and chief operations officer).
- Directors – who represent the voice of shareholders to the officers. They help set strategy and policy for the business.
A single person can be a shareholder, officer and director. In smaller corporations, it’s common for a handful of people to hold all three roles.
In this setup, shareholders own the corporation and the corporation, in turn, owns the business. This arrangement creates significant legal separation between the owners and the business. If the business owners work at the business, they are paid wages and receive a W-2 tax form just like any other employee.
Types of corporation
There are C corporations and S corporations. A C corporation pays tax on its profits and has fewer restrictions on who can be shareholders. An S corporation is a pass-through tax structure, but has to observe a few extra shareholder rules.
Shareholder rules for S corps:
- An S corporation can’t have more than 100 shareholders at any one time.
- Shareholders must be US citizens or permanent residents.
- It can’t sell shares to other businesses (although certain domestic trusts and estates are allowed).
- It can only issue one class of stock. By contrast, C corporations can sell different classes that give certain stockholders different rights.
Pros of an S corporation
Personal asset protection
An incorporated business is its own legal entity. If it gets sued, creditors can only seize assets owned by the business, not the personal assets of its owners. That doesn’t mean owners are exempt from any personal responsibility. They may still be sued if they’re at fault for negligent activity by the business. They may also be asked to sign a personal guarantee for a debt, and therefore have personal responsibility for it.
S corporations don’t typically pay income tax. Instead, S corporation profits are distributed to shareholders who pay personal income tax on their share of the business income.
Why that’s different from a C corporation
C corporations pay tax on their profits. If they choose to distribute money to shareholders as a dividend, it gets taxed again on their personal income tax return. This results in double taxation.
Why it’s also different from a sole proprietor
The income earned by S corporations is taxed on the owners’ personal return like a sole proprietor, but they don’t pay self-employment tax on those earnings. S corporation shareholders aren’t automatically considered to be working for the business. If they do work for the business, they must draw a salary just like any other employee, with the business paying payroll taxes.
Adopting corporate structures and processes can support more strategic decision making. The discipline of defined responsibilities, board meetings and reporting can help a business mature.
Things you should know about being an S corporation
Forming a business into its own legal entity takes some work. You will need to have documents prepared and filed that explain what the business does, how it will be organized, and who sits on the board. You will also have to demonstrate that the business is meeting its obligations as a corporation, which may require you to submit annual reports and document meetings. These jobs are often technical and require the input of professionals.
You’ll need to pay fees when filing to become an S corporation and there may be modest ongoing costs depending on what state you’re in. Then there are the indirect costs of forming and running a corporation, such as getting legal support for the filing process and preparing annual reports (required in some states). You also need a registered agent to act as a point of contact in any state you operate. If you don’t have staff to perform that role, you may need to pay someone to act as your registered agent.
You’ll need to run payroll
A corporation must pay a salary to its employees, even if they’re owners in the business. That requires the business to run payroll, issue pay stubs, and file payroll tax returns with the IRS and local tax authorities. It’s common to use payroll services for these tasks, which incur fees.
Stock ownership restrictions
S corporation rules may limit your ability to raise capital by bringing in certain types of shareholders.
How to form an S corporation
Forming an S corporation is complex and is typically handled by a business attorney. Here are some of the steps involved.
- Choose a name: You’ll need an official “entity name,” which will be how your home state identifies you and addresses mail to you. If you use a different name with your customers, you’ll need to register that as a “doing business as” (DBA) name. Both of these are done at a state level. To legally protect your name so that others can’t use it, you’ll need to trademark it with the United States Patent and Trademark Office.
- Establish a board of directors: You’ll need to elect a board of directors and schedule regular meetings. For small S corporations, directors are typically owners (and often also officers).
- Issue stock to owners: Stocks must reflect the proportion of ownership, which in turn determines their share of annual profits. Stocks also authorize holders to elect board members and vote on corporate policies.
- Appoint a registered agent: You need a registered agent to receive important legal and government correspondence on behalf of the business. They can be an employee of the business, or you can use a registered agent service.
- File Articles of Incorporation form: This form spells out what the business does and how it will be managed. After lodging this, you’ll need to settle on bylaws that set schedules and rules for board meetings.
- File form 2553 with IRS: Once all your other paperwork has been approved, you’ll submit form 2553, "Election as a Small Business Corporation," with the IRS.
S corp vs LLC
An LLC creates a legal separation between a business and its owners – just as an S corporation does – but it doesn’t come with any specific tax status.
However an LLC can ask the IRS to tax it as an S corporation. An LLC doesn’t have to establish a board of directors to achieve S corporation tax status, but it does have to abide by the S Corporation ownership rules.
Frequently asked questions about S corps
People who ask “what is an S corporation” also ask these questions.
Are S corp earnings subject to self-employment tax?
No. However, owners who are employed in the business must draw a salary for the work they do, and that salary will be subject to both income and payroll tax. Profits that are distributed to owners are generally subject only to income tax.
Can a C corp become an S corp?
Yes, if a C corporation fulfills the requirements of an S corporation, it can file the relevant paperwork (Form 2553) with the IRS.
How do I know my business is eligible for S corporation status?
A business must be US based with no more than 100 existing shareholders (owners), all of whom must be domestically based as well. As a general rule, those existing shareholders need to be individuals. Learn more about IRS rules for S corporations.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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