What Is a S Corporation Business and How It Works

Key Takeaways

• An S corporation is a special IRS tax designation for corporations that enables pass-through taxation while offering limited liability protection.
• S corporations must meet specific requirements, including shareholder limits and eligibility criteria.
• Profits and losses pass through to shareholders' personal tax returns, avoiding double taxation.
• Owners who work for the S corp must be paid a reasonable salary subject to employment taxes.
• The structure can offer tax planning flexibility and reduce self-employment taxes, but it also includes limitations on stock types and shareholder types.
• S corporations differ from LLCs in terms of ownership structure, operational formality, and tax flexibility.
• Some states treat S corporations differently or do not recognize the designation for state tax purposes.
• You can find a qualified attorney on UpCounsel to help you navigate forming and managing an S corporation.

The S corporation is typically preferred by small-business owners rather than a C corporation. As a corporation it still allows the owners of a business to be protected from liabilities with some tax benefits.

Conditions on Becoming an S Corporation

• There is a limit of 75 shareholders in the corporations.
• A husband and wife are considered to be one shareholder. (Note: It is very usual for S corporations to have one shareholder also serving as the only officer and director.)
• Must let the count of shares of stock they wish to grant to the shareholders be known.
• Each shareholder is given a certificate based on their ownership value of the S corporation.

Additional S Corporation Formation Requirements

To qualify as an S corporation, businesses must not only adhere to the shareholder and stock limitations already discussed but also:

• Be a domestic corporation or entity eligible to elect to be treated as a corporation.
• Have only one class of stock (though differences in voting rights are allowed).
• File IRS Form 2553, Election by a Small Business Corporation, signed by all shareholders.
• Elect S corp status no more than two months and 15 days after the beginning of the tax year in which the election is to take effect.

Failing to meet these criteria may result in disqualification or rejection of S corporation status.

Who May be Considered a Shareholder

• Individuals
• Estates
• Certain trusts
• Certain partnerships
• Tax-exempt charitable organizations
• Other S corporations provided they are the sole shareholder

Restrictions on Stock and Shareholder Structure

While S corporations are allowed only one class of stock, the IRS permits differences in voting rights. However, they may not issue preferred shares, which could limit fundraising options. Additionally, nonresident aliens cannot be shareholders, and certain trusts must qualify under IRS rules to hold S corp stock.

These restrictions aim to preserve the simplicity and pass-through nature of the S corp tax structure.

S Corporations and Taxes

• The corporate tax on company profits are not paid by corporations. The money made or lost is instead recorded on the shareholders' individual tax return at their own tax rate. S corporations still have to file an informational tax return known as the 1120S.
• With an S corporation, earnings and losses go through to shareholders and go on their individual tax returns. This way there is only one level of federal tax to pay. Due to being taxed as an individual rather than a company, money can later be directed to the owner with no further tax consequences.
• An S corporation's status may be canceled by either failing to meet the conditions of eligibility or by filing with the IRS too late after the beginning of the taxable year. If this happens, the business is then taxed as a corporation.
• S corporations are handled differently from state to state. Some states disregard S corporation status altogether and allow no tax break at all. Other states automatically do the opposite. Various states request that a state-specific form be filed in order for a company to achieve the status of an S corporation. An attorney in your state should be sought to assist you in becoming familiar with the rules that apply to your business.
• If a shareholder works for the company, the IRS requires them to take salary. They must report two kinds of earnings on a 1040 form. This includes their salary (form W2) as an employee, as well as their investment amounts (form K) as a shareholder.
• Payroll expenses are deducted by the company.
• The IRS recommends paying yourself a fair salary for your services along the lines of what you could earn elsewhere. The guidance on this by the IRS is minimal, allowing for some freedom on allotting executive salaries. An audit occurrence is very likely if no salary is paid, and an IRS assessment of employment taxes, penalties, and interest are all done through income.

Tax Advantages and Drawbacks of S Corporations

The main tax benefit of an S corporation is the elimination of double taxation, which typically occurs in C corporations. S corps also help reduce self-employment taxes, as shareholders can receive part of their compensation as distributions not subject to employment taxes.

However, there are some potential downsides:

• Reasonable Compensation Scrutiny: If the IRS believes a shareholder-employee is underpaid to avoid payroll taxes, it may reclassify distributions as wages.
• State-Level Tax Variability: Some states, like New York and New Jersey, impose entity-level taxes on S corporations or require additional filings.
• Complex Compliance: Although they avoid corporate tax, S corporations must still meet formal corporate governance standards, such as issuing stock and holding regular board meetings.

When Self-Employment Taxes Should be Considered

• Owners intend to work for the company.
• There is a single owner.
• It is family members who are the owners.
• Shareholders are acquaintances or friends.
• Company has no plans of going public to attract investors.
• Less than 10 percent of owners intend on offering consulting, accounting, engineering, law, etc, services to the public.
• Owners plan to take most of the profits from the company.

How S Corporations Minimize Self-Employment Taxes

In a sole proprietorship or partnership, all net income is typically subject to self-employment taxes. In contrast, an S corporation allows owners to split income into:

1. Salary: Subject to payroll and income taxes.
2. Distributions: Not subject to self-employment taxes.

This structure often results in lower overall tax liability, provided the IRS's "reasonable compensation" rule is followed. Salaries must reflect what the shareholder would earn for similar work elsewhere to avoid penalties.

The Cash Method

The cash method of accounting can be used by S corporations, which is easier than the accrual method. According to this particular method, earnings are taxable when received and costs are deductible when issued. This procedure allows the owner of an S corporation to remove money more simply and manage the employment taxes paid on executive salaries.

Accounting and Recordkeeping Requirements

S corporations often use the cash method of accounting unless they have inventory or exceed $25 million in gross receipts. However, maintaining S corporation status also involves adhering to corporate formalities, including:

• Holding annual shareholder meetings
• Keeping meeting minutes and corporate records
• Filing annual reports with the state
• Maintaining separate business and personal financial records

Failure to follow these practices could risk piercing the corporate veil and losing liability protection.

What S Corporations and LLCS Have in Common

The similarities LLCs and S corporations share is that they provide their owners protection from liability that is limited and are both considered pass-through tax entities. On a pass-through taxation, the money made or lost by the business is shown on the personal income tax return of the owners. This special tax status prevents double taxation for LLCs and S corporations.

Key Differences Between S Corporations and LLCs

Although S corporations and LLCs share the benefit of pass-through taxation and limited liability, they differ in several areas:

Choosing between an LLC and an S corp depends on business goals, tax strategy, and future growth plans.

Frequently Asked Questions

1. What is a S corporation business?
   An S corporation business is a corporation that meets specific IRS requirements to be taxed under Subchapter S, allowing profits and losses to pass through to shareholders' personal tax returns.
2. How does an S corporation help reduce taxes?
   S corporations can reduce self-employment taxes by allowing shareholders to take part of their income as distributions, which are not subject to payroll taxes.
3. Can an S corporation have multiple owners?
   Yes, an S corporation can have up to 100 shareholders, all of whom must meet IRS eligibility criteria (e.g., must be U.S. citizens or residents).
4. Is an S corporation better than an LLC?
   It depends. S corporations offer potential payroll tax savings but come with stricter rules and formalities. LLCs provide more flexibility but may result in higher self-employment taxes.
5. Can an S corp have investors?
   Only limited types of investors are allowed—individuals, certain trusts, and estates. Venture capital firms or foreign investors generally cannot hold S corp stock.

The benefits of incorporating a small business as an S corporation are certainly worth considering. Some benefits include tax breaks and reduced risk of liability. To become more familiar with how an S corporation operates, you can post your legal need on Upcounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.