Businesses that file for S Corp status will become a separate legal entity that is independent of its owners. Corporations have many of the same rights and responsibilities that an individual possesses. For example, a corporation has the right to loan and borrow money, enter into contracts, hire employees, own assets and pay taxes, and to sue and be sued.

Why Choose an S Corporation?

When a business incorporates, it automatically becomes a C corporation. A C corporation is legally viewed as an individual entity, separate from its owners, the stockholders. On the other hand, an S corporation is considered a "pass-through" entity, which means the business itself doesn't pay tax. Instead, the income is reported on the owner's personal tax return. In other words, S corporations have a special tax relationship setup with the Internal Revenue Service (IRS).

In both S and C corporations, the individual stockholders own the company. These shareholders will have limited liability protection, meaning they will not be held personally responsible for the liabilities and debts of the corporation. The default form of incorporation is a C corporation.

S corporations are entities that elect to pass corporate income, losses, credits, and deductions through to their stockholders for federal tax purposes. Shareholders that have invested in a C corporation will be subject to double taxation because they will pay taxes as both a stockholder and as an individual. The main advantage of an S corporation is the pass-through taxation that a shareholder receives. To be more specific, the income generated from the business is passed to the stockholder instead of being taxed at both the corporate and personal level, like with a C corporation.

The main advantage of an S corporation is the pass-through taxation that a shareholder receives. To clarify, the income generated from the business is passed onto the stockholder instead of being taxed at both the corporate and personal level, like with a C corporation. IRS rules dictate that owners of an S corporation must meet the following guidelines:

  • May not exceed more than 100 owners.
  • Must be U.S. residents or citizens.
    • May not be a nonresident alien.
  • May not be other S corporations, C corporations, partnerships, Limited Liability Companies (LLCs), or some trusts.

Other IRS limitations include:

  • The business must be a domestic corporation.
  • There may only be one class of stock.

Some professions, such as architects, lawyers, and doctors, may be required to form a Professional corporation (PC).

Advantages of Forming an S Corporation

Incorporating your business will completely separate your personal assets and liabilities from those of your business. The main advantages to forming an S corporation include:

  • Pass-through taxation.
    • Only taxed at the employee/owner level.
  • Limited personal liability protection.
  • Ability to easily transfer ownership of the corporation.
  • Unlimited life of the business.
  • Ability to easily raise capital.
  • Ability to trade equity to raise capital with up to 99 other shareholders.
  • Increased perceived credibility.
  • Pro-rata allocation of profits.
  • Net income/loss passed on to shareholders.
  • Decreased audit risk.
  • Additional business expenses may qualify as tax deductible.
  • Tax savings on self-employment tax.
  • Owners are allowed to receive salaries and distributions/dividends.
  • Cash-based accounting remains an option as long as no inventory for resale is held by the business.

Disadvantages of Forming an S Corporation

The main disadvantages to forming an S corporation include:

  • Complex tax laws.
  • Compliance and formation fees.
  • Ongoing bureaucratic formalities.
  • Additional administrative paperwork.
  • Eligible shareholder restrictions.
  • Owners must pay themselves a reasonable salary.
  • At least 75 percent of the income must be the result of active income streams.

Steps in Forming an S Corporation

In order to form an S corporation, the articles of incorporation must be submitted to the state in which you're incorporating. Also, all necessary filing fees must also be paid. Form 2553 must be submitted to the IRS in order to elect S corporation status. The form must be filed in a timely fashion; the deadlines are listed on the IRS website. After incorporation, the following steps must be taken:

  1. Adopt bylaws.
  2. Conduct a meeting of shareholders and directors.
  3. Issue shares of the company's stock.

Remember, most of the requirements for an S corporation are exactly the same for a C corporation.

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