Advantages of S Corporation: Everything You Need to Know
Business owners select S corporation status through an election they make with the Internal Revenue Service (IRS). 3 min read
The advantages of an S corporation are pretty enticing. For federal tax purposes, an S Corporation is treated as a pass-through company. Business owners select S corporation status through an election they make with the Internal Revenue Service (IRS). You create an S corporation by filing Articles of Incorporation with your state's Secretary of State or the governing body for corporations in your state.
An S corporation is run like a corporation. It issues stock, has directors and officers, and there are shareholders. The directors, officers, and shareholders act in the same capacity as they do in a C corporation. Plus, the owners and shareholders also enjoy the same liability protection as the owners of C corporations. Many businesses prefer S corporations for the single-taxation benefit and limited liability.
Who can Qualify to be an S Corporation?
Not all businesses are allowed S corporation status. There are several restrictions the IRS places, including:
- No foreign corporations may elect S corporation status.
- All shareholders must be permanent residents or U.S. citizens.
- LLCs and limited partnerships may not own shares of an S corporation because they are not U.S. citizens. They are business entities.
- There may only be as many as 100 shareholders in an S corporation.
There is a deadline you must follow to make the election. When creating a new business, you only have 75 days to make the S corporation status election with the IRS to enjoy the tax benefits of S corporation status during the year you start the business.
After the 75 day election period businesses may apply for S corporation status for the next tax year by submitting Form 2553 within 75 days of the tax year they want the benefit in. So, if you want S corporation status in 2020, you need to apply before March 15, 2020, to receive S corporation status for 2020.
When it comes time to transfer business ownership or dissolve a company the S corporation structure is particularly beneficial. An S corporation also protects the shareholders' personal assets. The only time an S corporation does not protect your personal assets is if you give an express personal guarantee.
The S corp is a pass-through entity for most state and income tax requirements giving it the same taxation benefits of the LLC. Most tax deductions, losses, business income, and credits are passed through to you instead of being taxed on the corporate level. The benefit of pass-through taxation is the avoidance of any "double-taxation."
Shareholders of an S corporation may be employed by the S corporation and receive a salary as an employee. S corporation shareholders may also receive dividends and distributions from the S Corporation. They may also make tax-free investment contributions to the S corporation.
An S corporation deducts payroll expenses and federal income tax and pays employees a "reasonable" yearly salary based on the industry standards. After all expenses are paid, the remaining profits are taxed at a lower rate and paid to shareholders as dividends.
With an S corporation, you may transfer interest in the company freely. In an LLC or limited partnership transferring more than 50 percent ownership triggers the immediate termination of the business entity. Furthermore, the S corporation does not have to comply with confusing accounting rules when ownership interest transfers to a new owner or shareholders.
Unless an S corporation has inventory, they do not have to use the accrual accounting method. C corporations are required to use the method unless they are small C corporations with less than $5 million in gross receipts for the year. Operating an S corporation, at times, helps new businesses establish credibility with potential employees, customers, partners, and investors. Investors like to invest in corporations as opposed to LLCs and limited partnerships.
It is much easier to convert a C corp to an S Corp than an LLC. You do not need to file anything with the SOS to make the switch. Just fill out and turn in Form 2553 before the deadline.
S corporation status is good for businesses who:
- Provide consulting services
- Have low start-up costs
- Do not need expensive equipment to begin operating
- Make a large amount of income without a huge expense
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