How Does an S Corporation Work: Everything You Need to Know
The S corporation is typically preferred by small-business owners rather than a C corporation. 3 min read
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.
Who May be Considered a Shareholder
- Certain trusts
- Certain partnerships
- Tax-exempt charitable organizations
- Other S corporations provided they are the sole shareholder
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.
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.
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.
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.
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.