Corporations are the most popular form of business structure. Although corporations offer more protection, they also have some disadvantages. Many companies choose to opt for S corp status with Internal Revenue Service. They also follow the Internal Revenue Code guidelines. Why? You may be able turn your business into an S corp entity, which can help you avoid tax penalties and protect yourself from liability.
What is an S Corp?
Subchapter S is the first chapter in the Internal Revenue Code. However, it is commonly referred to as a business entity structure but is actually a tax option that allows a company to have the liability protection of an LLC or partnership while still enjoying the tax benefits of an S corporation.
Businesses are subject to double taxation in a traditional corporation. This means that the income of the corporation is taxed and shareholders pay income tax on their profits. Scorps have a different tax process than a sole proprietorship, partnership or LLC. All profits and losses are passed through to the owners’ individual tax returns. An S corporation does not have corporate-level taxes. The business does not have to file separate taxes.
An S corp has the same personal liability protection as other companies. The owners of the business do not have to pay any legal or financial obligations.
Who should form an S Corp?
Businesses that are already LLC or corporation can apply for S corp status. This status is available to businesses that have been formed and have a federal tax ID. There are, however, eligibility requirements.
An S corporation is a domestic company with no more than 100 shareholders that issues one stock class. These businesses cannot have foreign shareholders, corporations, partnerships or other entities as shareholders. This election is not open to financial institutions or insurance companies.
Steps to electing S Corp status
You will need to choose an S corp status based on your business type and where you live. These are general steps. However, your situation may have some variations.
1. Your LLC or C corp can be formed
To form a business, you will need to complete all the necessary steps. You will need to choose a name and file Articles of Incorporation at the Secretary of State. Name a registered agent, draft articles or incorporation, make bylaws, and name members and corporate officers.
2. Get a federal tax ID Number
You will need a Federal Employer ID number to start a business. Also known as an EIN, FEIN, or Tax ID, this number is required. This number will have nine digits that the IRS will use to track your taxes and to refer to your company in the same manner as a Social Security Number.
After your company is legally formed, you can go to the IRS website to apply online for an EIN. The application can be sent by fax or post.
3. You must meet all requirements
Before applying for S corp status, ensure that your LLC/corporation meets all requirements. This means that you can’t have issued more than one stock type, and the number must be less than 100. They can be individuals, trusts, estates, corporations or partnerships.
You cannot also be an ineligible company such as an insurance company, financial institution, or domestic international sales organization.
4. File S Corp election paperwork
You can submit form 2553 Election by a Small Business Corporation to the IRS if you meet the IRS requirements.
You must comply with the filing requirements to allow your S corp status for the current tax year to apply. You must also complete the process within 15 days and two months before the tax year start. Your election will be valid for the next tax year if it falls within this timeframe.
5. Keep requirements in mind
Like any other corporation, an S corp must keep all annual requirements such as filing annual reports and recording minutes at annual meetings. They must also continue to meet the requirements for an S corporation. Although you don’t have to reapply to the S corp election again, LLC owners who fall outside the criteria must return to a C corporation or LLC taxation structure. Failure to report the change could have tax or even legal consequences.
S Corps has many advantages
While S corporations are great for tax purposes, business owners prefer the status of a s corporation for a variety of reasons.
An S corp structure has the primary advantage of avoiding double taxation, which other corporations are subject too. An S corp, as a pass-through entity is exempt from federal tax. Instead, shareholders file income tax returns and pay taxes on profits and losses they receive after the business has “passed through”.
The profit is not subject to the same tax as other income, making it a better option for owners. If the business experiences a loss, the owner may use the profit to offset other income on their tax return. While state laws regarding income taxes can vary, federal tax protection is the primary reason an S corp may be chosen.
Protection from liability
An S corp owner is protected from all liability, just like any other business structure. The company debts and legal issues are protected from the owners’ personal assets. Individual owners are not liable for company debts or liabilities if the company is sued.
Tax consequences can result from the transfer of ownership in some cases. These transactions are not subject to penalization by S Corps.
Dividend and salary payments
A shareholder can also be an employee, who receives a salary from the company in many cases. A combination of a salary and a payout can result in a lower tax bill because the dividend is not subjected to self-employment taxes. The S corp can deduct the salary paid when computing its passed-through income.
S Corps’ Disadvantages
Guidelines and regulations
Businesses must meet certain criteria to be eligible for S corp status. They must also meet a set number of requirements for the future. These include holding annual meetings, recording minutes, nominating directors, and recording shareholder activity. This administrative regulation can be time-consuming for smaller companies and result in higher annual fees than other structures.
S corporations have also had their records scrutinized by the IRS to ensure they comply with all guidelines.
Variable depending on the state
An S corp is a tax structure that the IRS has created. However, income taxes are not allowed in certain states. These states will apply all state taxes the same way they apply to C corporations. This could make taxes more complex and increase the cost at the state level.
What is the difference between an LLC and an S Corp?
A Limited Liability Company (or LLC) is a legal entity through which businesses can be created. An LLC can opt to use the S corp tax structure, which is how their profit and loss will be taxed. An LLC can be made an S corp if it meets certain criteria. However, not all LLCs qualify as S corps. An S corp can be created if the original business was a corporation.
Is it possible for any company to be an S Corp?
A business must meet certain criteria to be eligible for an S corp. This includes a limit of 100 shareholders. They must also be nonresident aliens or private individuals. Also, the business cannot issue more than one stock class. This means that members can only have the same amount of stock. Failure to meet these four criteria will result in a business being ineligible for an S corp election.
Brian Wilson is the content manager and founder of LLC Radar.
Brian grew up in North Texas, just outside of Dallas, and has a bachelor’s degree in business journalism from Southern Methodist University. Since graduating from SMU, Brian has gained over 10 years of experience in business writing for several online publications.
Brian resides in Plano, Texas and he can be reached by email: firstname.lastname@example.org