Business Entity: What Is An S-Corporation?

An important choice that every business owner must make is how to classify their business. There are a number of different business entities to choose from, such as a Limited Liability Company (LLC), Sole Proprietorship, and S-Corporation.

An S-Corporation, also known as an S-Corp or Subchapter S corporation, is a flexible option for individuals or shareholders wanting to create a corporation. This business structure allows shareholders to avoid certain taxes and save money. This corporation type also offers helpful protections including pass-through status and limited liability. Shareholders play an essential part in the development and growth of S-Corps. Consider the following benefits and drawbacks of an S-Corp.

What Is an S-Corp? 

For your business to be classified as an S-Corporation for tax purposes under the Internal Revenue Code, your business must meet the Internal Revenue Service (IRS) criteria:

• Be a domestic corporation 
• Have only allowable shareholders such as certain trusts, estates, and individuals 
• Have no more than 100 shareholders 
• Have only one class of stock 

The following types of corporations are ineligible:

• Certain financial institutions
• Insurance companies
• Non-US corporations 

To register your business as an S-Corp, you must submit Form 2553, Election by a Small Business Corporation, signed by all the shareholders. 

What Are the Benefits of an S-Corp? 

There are several benefits to consider if you’re interested in forming an S-Corp including: 

• Pass-Through Status –This means you’ll pass your business income, losses, deductions, and credits to shareholders without having to pay corporate tax.
• Limited Liability – Shareholders are not personally liable for the actions of the company. Their personal assets remain separate from any assets that the S-Corp has.
• Taxation – Profits and losses in an S-Corp pass through to stakeholders. That means that you’ll pay taxes once instead of being charged for the profits that the corporation earns.
• Lower Medicare & Social Security – Owners of corporations who are also employees are not responsible for these taxes. Instead, they only pay taxes based on their compensation.

Can You Pay Yourself a Salary in an S-Corp? 

S-Corp owners must pay themselves a reasonable salary. A "reasonable salary" can vary, but it is the equivalent of what employees in your industry earn for similar work. To determine a reasonable salary for yourself and your shareholders, think about: 

• Compensation agreements 
• Dividend history 
• Duties and responsibilities 
• Payments to non-shareholder employees 
• Time and effort devoted to the business 
• Training and experience
• What comparable business pay for similar services

What Are the Downsides to an S-Corp?

There are a few downsides to consider if you’re interested in an S-Corp. First, this business structure required to file both federal and state taxes. This includes Articles of Incorporation and corporate minutes. You’ll also hold regular shareholder meetings and pay required government fees if you form an S-Corp.

There are also shareholder restrictions to consider. Shareholders pay taxes on income that the S-Corp receives, even if the shareholder didn’t receive any of the revenue. Finally, the Internal Revenue Service (IRS) requires each business owner and officer of an S-Corp to make a salary, even if the company has yet to make a profit.

What Else Should I Know? 

As an S-Corp, your corporation can avoid double taxation. S-Corps are pass-through tax entities, meaning that the corporation isn't taxed on its profits. Profits passed onto shareholders are taxed as personal income.

Shareholders can receive dividends - the remaining profits after paying expenses. Shareholders do not have to pay a self-employment tax on these earnings.

Since S-Corp shareholders are employees, any earnings are subject to the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA). You must withhold some of your income for federal income taxes and report any earnings on your and the shareholders' personal income tax.

It is possible to operate an S-Corp as an independent contractor instead of an employee. If this is the case for you, you'll fill out a W-9 and pay a self-employment tax of 15.3%.

Finally, to form your S-Corp, you'll need to:  

• Some Secretaries of State work with S-Corps. If your state does, choose a legal name and reserve it through the state. 
• Draft and file Articles of Incorporation with your Secretary of State
• Issue stock certificates to initial shareholders
• Apply for all certificates and licenses relevant to your corporation
• File for a Form SS-4 (Application for Employer Identification Number) with the IRS to obtain an EIN
• Apply for any other ID numbers that your local government and state require
• Complete and submit Form 2553 (Election by a Small Business Corporation) within 75 days of forming your S-Corp

How to Pick the Best Business Entity For You

Choosing the right business entity is a critical decision that can impact your business's legal structure, taxation, liability, and growth potential. Let's dive into the differences between S-Corps, LLCs, and C-Corps.

S Corps vs. LLCs

Both an S-Corporation and a Limited Liability Company (LLC) offer limited liability protection and pass-through taxation, however, there are some differences:

• Ownership and Structure – S-Corps have more restrictions on ownership, such as a limitation on the number and type of shareholders, while LLCs are usually formed by sole proprietors, which allows for greater flexibility in ownership and management structures.
• Self-Employment Taxes – S-Corp shareholders who actively participate in the business can potentially save on self-employment taxes by paying themselves a reasonable salary and taking the remaining profits as distributions. In an LLC, all members are subject to self-employment taxes on their share of the profits.
• Formalities and Compliance – S-Corps have more formalities and compliance requirements, including the need for annual meetings, minutes, and maintaining certain corporate records. LLCs have fewer formalities and less stringent compliance obligations.
• Investor Attraction – If attracting outside investors or venture capital is a priority, LLCs may face challenges due to their less traditional ownership and management structure. S-Corps, with their ability to issue multiple classes of stock, may be more appealing in such scenarios.

S Corps vs. C Corps

Both S-Corps and C-Corps offer limited liability protection and are separate legal entities with their own tax identification numbers. With that being said, there are some differences to be aware of:

• Taxation – S-Corps have pass-through taxation. C-Corps have a corporate tax, potentially leading to double taxation if dividends are distributed to shareholders.
• Ownership and Shareholders – S-Corps have restrictions on the number and type of shareholders, whereas C-Corps can have an unlimited number of shareholders and different classes of stock.
• Growth Potential – C-Corps are more suitable for businesses seeking significant growth, as they can issue different classes of stock, making it easier to attract investors and raise capital.
• Formalities and Compliance – C-Corps have more formalities and compliance obligations, such as holding regular board meetings, maintaining minutes, and following specific corporate governance rules. S-Corps have similar requirements but often with less complexity.

Work with the Professionals

S-Corps offer advantages to owners and shareholders that ensure success. While beneficial, the process can lead to confusion, and you may need answers or clarification. It may be helpful to work with a small business tax accountant if you are unsure of the S-Corp application and formation process. An accountant will assist you through the S-Corp process. Don’t hesitate to seek advice from the experts to guide your corporation through this global crisis.