Are you undecided about whether to choose an S Corporation status for your new business?
Or, perhaps you’re unsure about the potential benefits and drawbacks? This article can be your comprehensive guide on the topic!
We’ll guide you through the basics, including:
- The definition of an S Corp
- Pros and Cons of S Corps
- Examples of what S Corps might look like
- Differences between S Corps and LLCs
- The process of setting up an S Corp.
Key Takeaways
- An S Corp is a corporation that lets companies use pass-through taxation, thus avoiding being double taxed.
- While there are tax benefits and liability protection, S Corps also have downsides in the form of closer scrutiny and more regulations.
- Understanding the differences between S Corps and LLCs is essential so that you can choose the right business structure.
- Setting up an S Corp is a multi-step process, ranging from choosing a business name to holding annual compliance meetings.
LegalZoom
Kickstart your business in minutes with LegalZoom's business formation services.
Start for free
We earn a commission if you make a purchase, at no additional cost to you.
What is an S Corporation?
An S Corporation is a corporation that uses pass-through taxation to allow the income, losses, deductions, and credits of the corporation to be passed directly to the shareholders.
The name “S Corporation” stands for “small business corporation”. Small businesses have had the option to elect S corporation status since 1958.
The status was designed to help small businesses stay afloat by providing tax relief through not taxing dividend distributions.
There are numerous IRS rules that a business must follow to qualify as an S Corporation. This includes having only one class of stock and having fewer than 100 shareholders.
Examples of S Corps
S Corporations exist in nearly every industry, but in general, they are small to medium-sized businesses that are privately owned.
Examples include:
- Real Estate Agencies: A small, specialized real estate agency that is family-owned and has less than 100 shareholders could benefit from S Corp status for tax benefits.
- Grocery Stores: A small chain of regional grocery stores with a small group of shareholders.
- Tech startups: If a technology startup maintains a single class of stock and has less than 100 shareholders, it could benefit from the pass-through taxation structure of an S corporation.
Pros and Cons of S Corporations
There are benefits and disadvantages of running a business as an S Corp. These include:
| Pros | Cons |
|---|---|
| Pass-through taxation – Companies can avoid double taxation by having income, losses, and deductions flow to shareholders | Restrictions on shareholders – the shareholders must be US citizens or residents, and there must be fewer than 100 |
| Less liability – Shareholders assets are protected from business debts | Less flexibility – Because S Corps can only have one class of stock, there is less flexibility when it comes to raising capital |
| Easy to transfer shares – Shares can be transferred without affecting corporate tax status | Shareholder salary requirements – Employees who are shareholders must be paid a “reasonable salary”, and this is subject to Federal tax |
| Business expense deductions – S Corps can easily write off losses and business expenses | More scrutiny – The IRS often closely scrutinizes S Corporations due to the tax benefits offered |
| Multiple owners – S corporations can have many owners and shareholders | Limited growth potential – due to the restrictions on the type of stock and number of shareholders, expansion opportunities can be curtailed |
S Corp vs. LLC
An LLC is a business structure that is designed to protect the owners from personal responsibility for their company’s debts or liabilities.
Let’s look a little closer at the differences between S Corps and LLCs:
| S Corp | LLC |
|---|---|
| Needs to register as a corporation, then separately file for S Corporation status with the IRS | Set up at the state level, with often fewer formation rules and requirements |
| No more than 100 shareholders, all of whom must be US residents or citizens | No rules about the number of shareholders or their nationality |
| Shareholders elect a board of directors to oversee the company | Management is flexible, with options for a member-managed or manager-managed structure |
| Pass-through taxation avoids double taxation | Defaults to pass-through taxation, although there is the option for corporate taxation |
| Limited liability protection for shareholders | Limited liability protection for members |
| Stringent regulatory requirements | Fewer requirements and reports required |
So, which one should you choose? The decision should be based on the individual needs of your company.
If flexibility and simplicity are important to you, an LLC could be your best option. They’re particularly popular for small businesses with a single number of owners.
If you plan to grow your business and possibly transition to a C corporation in the future, an S corporation may be a better option.
S corporations also offer reductions on employment tax.
Related reading: S Corp vs. Corp
IRS Qualifications & Requirements
The IRS has stringent rules surrounding what a business must do the qualify as an S Corp. These include:
- Be a US-based corporation.
- Have only allowable shareholders – this excludes partnerships, corporations, or non-resident, non-citizen shareholders.
- Have no more than 100 shareholders.
- Have only one class of stock.
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
How to Set up an S Corp
Here is the steps that you need to take an order to set up an S corporation.
- Choose a business name: Your name needs to reflect your brand identity, as well as comply with any state naming regulations.
- File articles of incorporation: This includes essential details such as the name of your business, purpose, and your stock details.
- Issue stock for your S Corp: Allocate shares of stock to your shareholders, establishing ownership percentages and defining the roles of each shareholder.
- Elect board of directors and officers: Choose a board of directors to oversee the company’s operational management.
- Meet S Corp eligibility requirements: Ensure your business meets all IRS requirements to qualify as an S Corp.
- Obtain an employer identification number: Apply for an EIN through the IRS.
- Elect S Corp status: File the IRS Form 2553. This needs to be done either within 75 days of setting up your business or within 75 days of the beginning of the tax year.
- Register local or state business licenses: Make sure you have all necessary local or state business licenses to operate your specific business.
- Create S Corp bylaws: Create bylaws to lay out the company’s rules, making a clear path for future decision-making.
- Schedule and hold annual meetings: Hold annual meetings to ensure compliance and make business decisions.
Quick Start – Use a business formation service like LegalZoom to help you with some of the details of this process, consider employing a business formation service to make the setup run smoothly.
Next Steps
Well done for making it to the end of this guide! You’ve taken the first step towards setting up your new business as an S corporation.
Ensure you keep learning and nurturing your curiosity as you embark on your journey to entrepreneurial success!
FAQ’s
Why should a company be an S Corp?
Being an S corp allows a company to gain benefits from pass-through taxation and avoid the double taxation experienced by the C Corps.
What is the difference between an S Corp and C Corp?
Primarily, the difference is tax-related. C corps are potentially subject to double taxation on dividends, while S corps are not.
C Corps also have no restrictions on the number and type of shareholders they can have, unlike S Corps.
How does an S Corp work?
In a S Corp, the corporate structure is combined with pass-through taxes, which means that business profits are taxed on the tax returns of individual shareholders rather than the corporate level.
Related reading:
- What is incorporation?
- What are Articles of Incorporation?
- Certificate of Incorporation: Everything you need to know
LegalZoom
Kickstart your business in minutes with LegalZoom's business formation services.
Start for free
We earn a commission if you make a purchase, at no additional cost to you.
