S Corporation

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The S Corporation (S Corp): What Is It?

S corporations are businesses that are permitted under the tax code to pass their taxable income, credits, deductions, and losses directly to their shareholders. The S corporation is available only to small businesses with 100 or fewer shareholders, and is an alternative to a limited liability company.

As “pass-through entities,” S corps and LLCs do not pay corporate taxes, but pay their shareholders instead, who are responsible for paying the taxes.

S Corporations (S Corps) – An understanding

Their name comes from Subchapter S of the Internal Revenue Code, under which they’ve elected to be taxed. A corporation filed under Subchapter S has the key characteristic of passing business income, losses, deductions, and credits directly to shareholders without paying any federal corporate tax – making it something known as a pass-through entity. As a result, it is eligible for some special tax benefits under the Tax Cuts and Jobs Act of 2017. On the other hand, it is liable for taxes on passive income and built-in gains at the corporate level.

S corporations are similar to any other corporation, or C corporation as they’re officially called. As a for-profit corporation, it is governed by the same state corporation laws as its parent company. A C corporation offers similar liability protection, ownership, and management advantages. The company must also observe internal practices and formalities, such as having a board of directors, writing corporate bylaws, and holding shareholder meetings.

 

An S corp and a C corp are taxed differently: Profits from a C corp are taxed when they are earned, and then are taxed again when they are distributed as dividends. Dividends may be paid directly to shareholders by an S corporation without paying federal corporate taxes.

The IRS’s requirements for S corporations

 

There are certain requirements that a business must meet in order to qualify for S corporation status with the Internal Revenue Service (IRS). The company must be incorporated domestically (within the United States), have a single class of stock, and not have more than 100 shareholders. Additionally, those shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations [501(c)(3)]. It is not possible to become a shareholder if you are a partnership, corporation, or a nonresident alien.

 

The advantages and disadvantages of S corporations

S Corporations have several advantages

  • One of the biggest benefits is not having to pay federal taxes at the entity level.1 Saving money on corporate taxes is especially beneficial for startups.
  • As a result of S corp status, business owners can also reduce their personal income tax bill. Tax liability for self-employment tax is often reduced for S corp owners by classifying money they receive as salary or dividends. Tax deductions for business expenses and employee wages are available to S corporations. For owners of S corporations, there are also tax benefits for pass-through entities.
  • S corp shareholders can work for the company, earn salary, and receive tax-free dividends if the distributions do not exceed their stock basis. Dividends that exceed a shareholder’s stock basis are taxed as capital gains, which are taxed at a lower rate than ordinary income.
  • In addition, you won’t have to comply with complex accounting rules or face adverse tax consequences when changing property basis.
  • By demonstrating the owner’s formal commitment to the company, S corporation status may establish credibility with potential customers, employees, suppliers, and investors.

The disadvantages of registering as an S corporation

  • Because S corporations can disguise salaries as corporate distributions to avoid paying payroll taxes, the IRS scrutinizes how they pay their employees. S corporations must pay reasonable salaries to shareholder-employees before making distributions.
  • S corporations must distribute profits and losses based on the percentage of ownership or number of shares each shareholder holds when making distributions to stakeholders.
  • An S corporation’s Subchapter S status may be terminated by the IRS on rare occasions if it fails to allocate profits and losses properly or makes other noncompliance moves, such as errors in election, consent, notification, stock ownership, or filing requirements. In most cases, noncompliance errors can be rectified quickly in order to avoid adverse consequences.
  • It takes time and money to set up an S corporation. Articles of incorporation must be filed with the Secretary of State in the state where the business is based. As part of the incorporation process, the corporation must obtain a registered agent and pay other fees.
  • Fees such as annual report fees, franchise taxes, and other miscellaneous charges are common in many states. Charges are usually inexpensive and can be deducted as costs of doing business. Regardless of whether investors have voting rights, they all receive dividend and distribution rights.
  • Businesses that are growing rapidly and are seeking venture capital or institutional investors might find the limits on the number and nature of shareholders onerous.

The pros

  • The owner pays no or less corporate and self-employment taxes, and the shareholders don’t pay double taxes
  • Incorporation protections: limited liability, transfer of interests
  • Credibility and prestige

The cons

  • Incorporation costs
  • Rules of compliance that are complex
  • Maintaining status with potential growth inhibitors

LLC vs. S Corp

Another type of legal business entity is the limited liability company (LLC). Small businesses often use this structure as well as the S corporation.

Other characteristics of LLCs and S corporations are also similar. The companies are both pass-through entities, which means they do not pay corporate taxes, and they provide limited liability protection for their principals and owners. In the event of a lawsuit filed against the company, the owners cannot be held personally liable for their personal assets, nor can business creditors touch their personal assets. Under the Tax Cuts and Jobs Act, LLC owners also receive tax benefits as pass-through entities.

The flexibility of LLCs, however, is greater than that of S corporations. They are not subject to IRS regulations regarding the number and type of shareholders/owners (called “members”), or to federal or state rules regarding governance, procedure, and fund distribution. Profits and losses can be allocated in whatever proportions the owners want.

LLCs are commonly formed by sole proprietors or small groups of professionals, such as attorneys, doctors, and accountants. As opposed to equity investors, they have fewer financing options – generally bank loans. They may not be able to grow as much as they would like.

Tax Return for an S Corporation in the U.S.

It is still necessary for S corporations to report their earnings to the federal government and file tax returns, even though they are largely exempt from corporate taxes.

A Form 1120-S is essentially the tax return for an S corporation. The Form 1120-S, which is often accompanied by a Schedule K-1 that shows the percentage of company shares owned by each shareholder, reports the corporation’s income, losses, dividends, and other distributions.

Unlike C corporations, which are required to file quarterly, S corporations only file once a year, like individual taxpayers. The Form 1120-S is also simpler than the tax forms for C corporations. Five pages were included in the version for 2021.

In general, companies that follow a calendar year must file Form 1120-S by the 15th day of the third month after the end of their fiscal year (generally March 15).

What are the reasons you would choose an S corporation (S corp)?

In small businesses, S corporations can provide the best of both worlds, combining the benefits of corporations with the tax benefits of partnerships.

The strength of S corporations lies in their limited liability protection, which means that business creditors or legal claims against the company cannot access an owner’s personal assets. The income and earnings they generate are not subject to corporate taxes, like those generated by partnerships. If their compensation is structured as a salary or stock dividend, they can also help owners avoid self-employment tax.

The S corporation stands for what?

In the Internal Revenue Code (IRC), Subchapter S describes S corporations. Under this section of the IRC, it is taxed. Subchapters of S corporations are also known as S corporations.

What is the structure of an S corporation?

The operation of an S corporation is similar to that of a regular corporation in many ways. It establishes a board of directors and corporate officers, bylaws, and a management structure under the laws of its home state. The company issues shares of stock. In the event of a creditor claim against the company, its owners cannot be held personally or financially responsible.

Unlike corporations, S corporations do not pay federal income taxes on most of their earnings, allowing more money to flow to shareholders (who do pay ordinary income taxes on the funds). A shareholder’s equity stake or number of shares must be taken into account when allocating funds.

The number of shareholders in a S corporation must be 100 or fewer, and they must be all individuals, nonprofits, or trusts. Stockholders and the corporation itself must be based in the United States.

At tax time, S corporations must distribute Schedule K-1 forms to shareholders, indicating the company’s annual profits or losses, and file Form 1120-S with the Internal Revenue Service (IRS).

 

 

Is a limited liability company (LLC) or an S corporation better?

An S corporation or a limited liability company depends on the size and nature of the business and its growth objectives.

Due to its flexibility and ease of establishment, LLCs are often preferred by sole proprietors or businesses with few partners. It might be better to form an S corporation if a business is larger-or aspires to be larger. The S corporation has more financing options: Unlike LLCs, it is allowed to offer equity stakes to investors as a form of capital. In addition, if their operations are complex, they should establish formal structures, compliance procedures, and other protocols required of corporations.

How do S corporations differ from C corporations (C corp)?

In one word, taxes are one of the key differences between S corporations and C corporations. The short answer is that C corporations pay them and S corporations don’t (most of the time).

In the same way that individuals pay income taxes, corporations pay corporate taxes on their earnings. The U.S. currently taxes corporations at a flat rate of 21%. Dividends or other profits are then distributed to shareholders after tax. Conversely, S corporations are exempt from federal tax on most earnings-with a few exceptions for capital gains and passive income-allowing them to distribute more profits to shareholders.

The IRS imposes certain restrictions on S corporations in exchange for this tax benefit. Both they and their shareholders must be based in the United States. They can have no more than 100 shareholders, who must be individuals, nonprofits, trusts, and estates—no institutional investors. Stocks can only be issued in one class.

 

These restrictions do not apply to C corporations. The size of an S corporation is generally smaller than that of a C corporation (though this isn’t always the case).

Here’s the bottom line

A S corporation is a common type of legal entity recommended for small businesses. They combine the tax advantages of partnerships with the limited liability protections of corporations. They are a kind of “corporate lite” structure with fewer requirements for setup and maintenance than regular corporations.

Corporations are subject to many of the same protocols as S corporations—starting with the fees and formalities associated with incorporation. In comparison to LLCs, another popular structure for small businesses, they require more time and money to establish and maintain.

However, fast-growing companies are subject to certain IRS restrictions on their size and shareholders, which may impede their expansion. Changing from S corporation status to C corporation status is relatively easy if business conditions are favorable.

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