What is an S Corps – and is it a good fit for your business?
Business owners have to make a lot of decisions, big and small. One of the major ones is how you decide to structure your company. To help you evaluate the options and make the right choice for your business, we’re outlining two of the most common company structures – LLCs and S Corporations – in a series of articles. Our previous article focused on Limited Liability Companies (LLCs), so here, we’ll dive into the details about S Corps.
The S Corps basics
In IRS lingo, S Corporations get their name from Subchapter S of the tax code. Companies that meet defined criteria can qualify as S Corporations, which is a special tax status that allows them to pass corporate income, credits, and deductions through to shareholders.
That means, rather than paying federal income taxes, an S Corporation’s shareholders report the income and losses on their personal tax returns, paying taxes at their individual income rates. As a result, an S Corporation is sometimes described as providing the benefits of incorporation with the tax status of a partnership. The objective behind forming an S Corporation is to avoid double taxation, which occurs when a corporation is taxed at the corporate level, and its shareholders are also assessed taxes at the individual level.
To form an S Corporation, a company must:
- Have 100 or fewer shareholders who each meet IRS eligibility requirements (Must be U.S. citizens, residents, or resident aliens; cannot be partnerships or other corporations)
- Be a domestic corporation – and cannot be a bank, insurance company, or domestic international sales company
- Have only one class of stock (i.e., no class A and B stocks entitled to different treatment or voting and non-voting shares)
- Gain the consent of all shareholders for S Corporation status
Weighing the pros and cons
Setting up and maintaining S Corporation status can be complex, so it’s important to evaluate the requirements against the potential tax savings. Plus, becoming an S Corporation comes with increased IRS scrutiny. If your company fails to meet any of the requirements, the IRS can revoke S Corporation status and assess taxes based on corporate rates at any time. If S Corp status is revoked, you won’t be able to reapply for five years.
S Corporations must hold regular shareholder meetings and formally track meeting minutes, by-laws, and stock transfers. And, while S Corporations don’t pay federal income taxes, shareholders must pay themselves “reasonable compensation” based on fair market value, as well as employment taxes (Social Security and Medicare) on employee wages. All other income may then be paid as “distributions” to shareholders, which are not subject to the self-employment tax.
Each S Corporation shareholder must be entitled to equal dividends. This ensures the corporation’s income and loss are determined by stock ownership, but it can also make it challenging to adjust the dividends for different shareholders.
All of the above applies to federal taxes. Your state may have different S Corporation rules. Make sure you understand how your state taxes S Corporations and factor that into your decision.
Finally, tax benefits aren’t the only advantages provided by S Corp status. As an S Corporation, shareholders can also reduce personal liability for the company’s debts or liabilities.
How to form an S Corp
Since an S Corporation is a tax status, you first need to structure your business as either a C Corp or an LLC. Then, in collaboration with your business and tax advisors, evaluate the qualifying criteria for S Corporation status carefully.
Once you’ve determined your business meets all IRS requirements, complete and submit Form 2553. This form must be signed by all of your company’s shareholders. Typically, you will be notified within 60 to 90 days of filing whether your application for S Corps status was accepted. Your S Corporation tax status then remains in effect until you terminate it or it’s revoked.
McCoy Accounting Advisors is here to help you evaluate the options and determine if S Corp status makes sense for your business. Contact us to learn more about our Business Advisory Services and schedule a complimentary consultation.