1. Basics of the S Corporation
2. How to Qualify as an S Corporation
3. Electing S Corporation Status
4. Drawbacks of S Corporations
5. S Corporation Passive Income
6. Choosing S Corporation Status for an LLC

An LLC subchapter S is a limited liability company that has chosen S Corporation taxation

Basics of the S Corporation

When you elect S corporation status for your business, there are a variety of benefits you can receive.

The most important reason to form this type of corporation is providing your company's shareholders with limited liability protections. When these protections are in place, your shareholders' personal assets will be protected from lawsuits against your company and legal issues involving other shareholders.

You can establish these liability protections by forming a subchapter S corporation. Limited liability is also a benefit of a traditional corporation. The primary difference between normal corporations and S corporations is that S corporations enjoy the benefits of pass-through taxation. With pass-through taxation, an S corporation does not pay taxes at the corporate level, which is similar to how partnerships are taxed. However, in some states, S corporations are still required to pay franchise fees.

S corporations are only allowed to have seventy-five shareholders, as dictated by the IRS.

It's very common for companies that meet this shareholder limit to elect S corporation status, as choosing this corporate structure prevents double taxation. S corporations have a few very important features:

  • The company and its owners are legally separate entities.
  • Corporate formalities must be recognized, including adopting bylaws and scheduling shareholder meetings.
  • Sharing of profits is restricted.
  • There are flexible options for distributing earnings. 

How to Qualify as an S Corporation

You will need to fulfill several requirements if you wish to elect S corporation status for your company. First, if you are starting a new company, then you must choose S corporation status within a 75-day period after forming your company. Your corporation must also be a conventional corporation, meaning it is operating for-profit and you only have one stock class. Your corporation's stockholders can only be permanent residents of the United States with good standing or United States citizens.

S corporations must have 75 shareholders or fewer, and the company's passive income cannot be more than 25 percent of gross revenue. Every state can have different rules for S corporation taxation. In Texas, you cannot form this type of corporation. 

Electing S Corporation Status

After your company has been formed, you will not automatically have S corporation status. To elect this tax status, you will need to fill out and file IRS form 2553. Submitting this form by March 15 will give you S corporation status for the whole calendar year. Although filling out this form should not be difficult, there are hard deadlines that you will need to file. For example, new corporations only have a 75-day period to elect this status after formation. 

Drawbacks of S Corporations

Essentially, an S corporation is a standard corporation that enjoys many of the benefits of a partnership, including pass-through taxation. Corporations that fail to abide by corporate formalities run the risk of losing their limited liability protections, potentially resulting in the piercing of the corporate veil. 

S Corporation Passive Income

When a corporate investment generates income, it is called passive income. The amount of passive income your corporation generates can impact your ability to qualify for S corporation status. Passive income is very different than active income, as active income results from the services or goods provided by the corporations.

Passive income can only total 25 percent of your corporation's revenue if you want to maintain your S corporation status. If you generate too much passive income two years in a row, the IRS may revoke your S corporation status. 

Choosing S Corporation Status for an LLC

Limited liability companies (LLC) are companies that are formed based on state law. LLCs are very easy to form and provide many of the same benefits you would receive with a corporation. After forming an LLC, you will receive a default tax status. For example, multi-member LLCs are taxed as partnerships.

LLCs have the ability to elect either C corporation or S corporation tax status by filing the correct form with the IRS. After filing the election form, the IRS considers the LLC to be a corporation.

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