Delaware S Corporation: Everything You Need to Know
A Delaware S corporation is a business entity that can avoid federal income taxes by electing to be taxed under subchapter S of the Internal Revenue Code.3 min read
2. Benefits of S Corp Status
3. Disadvantages of S Corp Status
4. Registering an S Corp in Delaware
A Delaware S corporation is a business entity that can avoid federal income taxes by electing to be taxed under subchapter S of the Internal Revenue Code. This type of corporation is formed by creating a general corporation in Delaware and then filing IRS Form 2553 to select S corp tax treatment. This must be done within 75 days of forming the company.
When a Delaware S corporation is successfully formed, it is subject to pass-through taxation. This means that income and losses of the business are reported on the individual tax returns for each shareholder. These earnings are taxed only once, unlike with a standard corporation where earnings are taxed at the corporate level and again at the individual level when they are distributed to shareholders.
Subchapter S election is designed to be used by small businesses and is a tax status, not a separate legal entity. It allows these companies to enjoy the liability protection of incorporation without being subjected to steep corporate taxes. Limited liability means that shareholders' personal assets are protected from being seized to settle outstanding business debts and legal obligations.
Some states require S corporations to elect this tax treatment at the state as well as the federal level, but Delaware automatically recognizes the federal status of an S corporation.
S Corp Qualifications
To elect S corp status in Delaware, a business must meet the following requirements:
- All shareholders must approve of the election.
- The corporation must have 100 or fewer shareholders.
- Shareholders must be individuals or their estates or trusts.
- Shareholders cannot be other companies or non-resident aliens that live in a U.S. state (not a territory). The exception is for non-profit organizations that are tax-exempt.
- Only one class of stock can be offered, though it can be divided among voting and non-voting shareholders.
- The corporation must not be a bank, insurance company, or current or former domestic international sales corporation.
- It must derive no more than 25 percent of its income from passive investments such as real estate.
Benefits of S Corp Status
Pass-through taxation is the main benefit of establishing a Delaware S corporation. Other benefits include:
- The ability to own up to 100 percent of shares of a C corporation.
- The ability to deduct early business losses.
- The ability to be a member of a limited liability company (LLC).
- Shareholders can pay themselves a salary.
- Single-member companies avoid being categorized as a personal holding company by the IRS and taxed accordingly.
- The ability to create retirement plans for stockholder employees and deduct the full amount of company contributions to these plans.
- Permission to use cash accounting, which is simpler than the accrual accounting system other corporations are required to use.
- Shareholders that work for the business are eligible for benefits such as group health insurance, profit sharing, retirement plans, stock options, and bonuses.
- Limited liability protection.
Disadvantages of S Corp Status
Despite the advantages of the S corp, it's not the best entity for every business. Possible disadvantages include:
- The 100-shareholder limit.
- The inability to issue more than one stock class.
- The inability to hold less than 100 percent ownership in another S corporation.
- The inability to own more than 80 percent of a non-S corporation.
- Benefits such as medical insurance given to shareholders who own more than 2 percent of the corporation are not deductible by the corporation.
- Some states do not recognize federal S corp status, which means an S corp doing business in those states is subject to double taxation at the state level.
- In some states, S corps are subject to capital gains taxes or taxes on passive income over a certain level.
- Shareholders of an S corporation are taxed on both dividends and earnings kept within the business. This means that all profits must pass through a shareholder for tax purposes even if the individual does not receive those funds.
Registering an S Corp in Delaware
A new Delaware S corporation must fill out one of two forms depending on whether or not you plan to issue stock. Both must include the name and address of the company and of the incorporator as well as the purpose of the business.
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