Learn how to form an S corporation and which documents you will need to file to qualify. Business owners can protect personal assets and reduce their business' tax liability by opting for S corp status.

What's an S Corporation, and How Do You Form One?

Also known as a small business corporation or subchapter, an S corporation is a tax code that protects you against personal liability. It lets you pay income-based taxes so you avoid double taxation, which regular C corporations are not able to avoid.

In order to incorporate a business, you need to figure out which state you want your business to be. You also need to determine where you will hire employees, where you will keep bank accounts, and from which states you will accept orders.

When selecting the name of your company, you need to determine if it is unique and can let you stand out from other companies. Search through the Secretary of State's website to find out if the potential name is available. You can add "Incorporated" or "Inc." to the end of the business name once you create an S corp.

After you select your company's name, you must file your articles of incorporation with the Secretary of State. If you incorporate in your home state, you can avoid having to file reports and make payments in other states. But if you do business nationally, you might want to incorporate in a business-friendly state and register to conduct business in other states.

From there, you need to prepare the company's bylaws, even though some states don't make this a requirement. You should also keep corporate minutes of all shareholder and board meetings. You can apply for an Employer Identification Number (EIN) once you submit an IRS Form SS-4.

Make Sure You Qualify for S Corporation Status

To qualify for S corporation status, you must be an eligible, domestic corporation. You must have one class of stock and have no more than 100 shareholders. You also need to adopt tax years ending on December 31, a natural business year, an ownership tax year, or a tax year listed under Section 444.

Once you form your corporation, you must file IRS Form 2553. You must do this no later than two months and 15 days after your chosen tax year begins. You will know within 60 days of filing if your application is accepted.

S Corp Advantages

Once you obtain S corporation status, you gain several key advantages, including limited liability protection. Other advantages include the following:

  • Easy transfer of ownership. S corporation shareholders can sell their ownership interest without needing approval of other shareholders. They also can transfer ownership without significant tax consequences.
  • Unlimited life. If an S corporation owner experiences a serious illness or dies, the corporation continues to exist.
  • Pass-through taxation. S corporations avoid double taxation since income goes to the shareholders' personal income tax returns.
  • Distribution of funds. Profits and losses end up in each shareholder's shares of stock.
  • Self-employment tax savings. S corps offer tax savings since owners are considered employees. However, the S corp must pay Social Security and Medicare taxes.

Disadvantages of Subchapter S

When your business grows, it might become more difficult to stay within the subchapter S sector. If you fail to follow all of the requirements the IRS has established for S corporations, you could lose the option to operate under this structure. Depending on your company's long-term goals, you might want to go with a C corporation structure early on. A C corporation doesn't have ownership limitations and includes several classes of stock.

Due to the flexibility S corporation status provides, your business could be subject to IRS audits more often than regular corporations. You run the risk of being asked to re-characterize your income and pay higher taxes if the IRS doesn't agree with how profits are distributed and reported. Avoid making mistakes on your IRS form relating to stock ownership, consent, and notification since you may lose your S corporation status as a result.

Why Not Just Go with an LLC?

While an expensive option to form, an LLC is considered the most tax-efficient and flexible business entity. Even though a subchapter S gives you the same general flow-through tax treatment, an LLC is more flexible when it comes to debt. It also has no restrictions on shareholders.

If you see your business remaining small for a while, only want U.S. shareholders, and don't need to borrow money, you should opt for a subchapter S. Even if your company does expand and takes in outside capital, you can void subchapter S status and become a regular corporation. If your current business doesn't meet S corp requirements or you plan to take on debt, opt for the LLC.

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