Becoming an S Corp: Everything You Need to Know
Becoming an S corp is the process of changing your tax election status to be considered an S corp for tax purposes by the IRS. 3 min read
Becoming an S corp is the process of changing your tax election status to be considered an S corp for tax purposes by the IRS. An S corp is a tax election status that lets your business be taxed similarly to a sole proprietorship or a partnership rather than a corporation. It was originally created to act as a bridge between small, domestic corps that ensured limited liability but had “double taxation” and partnerships that had better taxation but exposed at least one member to full liability.
Changing your tax election status to that of an S corp involves meeting certain S corp requirements and filing the correct form with the IRS. However, before this is done, one should be aware of the pros and cons of the S corp and be certain an S corp is the right business structure and tax election for them.
Pros of the S Corp
Electing the S corp status has several advantages, such as:
- No corporate taxation. This is the biggest draw to the S corp. S corps have pass-through taxation to your personal taxes so you won’t have to deal with double taxation.
- Taxable gains reduction. If the S corp is sold, it can qualify for reduced tax gains, meaning that selling your S corp can be part of a retirement strategy.
- Startup loss write-offs. With an S corp election, the losses and expenses incurred by your S corp in the early years can be offset by your personal income. Regular corps have losses locked with the company.
- Limited liability protection. S corps offer limited liability protection, although this is not complete protection from all liability. For instance, gross negligence is not covered.
- Ease of ownership transfer. With S corps, you can easily transfer ownership by selling stock.
- Unlimited life. An S corp’s existence is not tied to the life or health of the owner so it can theoretically exist forever.
- Ease of raising capital. You can easily raise capital in an S corp by selling stock.
- Increased credibility. S corps are perceived by many as being more credible or professional entities than general partnerships or sole proprietorships.
- Pro-rata profit distribution. According to the IRS’s tax rules regarding S corps, losses, profits, and anything else that is considered a pass-through item is to be allocated proportionally in accordance with the shareholder’s share of stock in the corporation.
- Less risk of audit. In general, S corps are less likely to be audited than sole proprietorships.
- Tax deductible expenses. Some S corp business expenses may qualify for tax deductions.
- Savings on self-employment taxes. With an S corp, one can save on self-employment taxes since the owners can be classified as employees if they work for the business.
Cons of the S Corp
Taking S corp election may have its downsides. These may include:
- One stock class. S corps are limited to having one class of stock only. This limitation means you will have less control over the company and limitations on your stock’s value.
- Decreased attraction to outside investors. Venture capitalists may not like pass-through taxation or a shareholder limit. If you desire such investments to grow your company, the regular corporate tax designation may be a better choice.
- Tax filing. Even though you do not have to pay corporate taxes, you will still have to file a yearly tax return, unlike non-corporate business structures.
- Corporate meetings. Corporations are required to hold meetings regularly and keep minutes of those meetings.
Changing Your Business to an S Corp
If you decide that the S corp is the right business structure for you and you wish to change your corporate status to S corp with the IRS, you must first make sure you meet several IRS requirements, including:
- That your business not have more than 100 shareholders (husband and wife may count as one shareholder).
- That your shareholders are US residents.
- That your company is a domestic, not foreign, company.
- That all shareholders agree to the change to S corp tax status.
Once you have ascertained that you meet these and other requirements, you must file Form 2553 with the IRS within two months and 15 days of the beginning of the tax year.
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