S Corp for Dummies: Everything You Need to Know
S Corp for dummies will provide you with the basic information you need in order to identify if operating an S Corp is right for you.3 min read
2. Compensation vs. Dividends
3. IRS Restrictions
S Corp for dummies will provide you with the basic information you need in order to identify if operating an S Corp is right for you. Businesses that want to incorporate are established as regular C corps and must elect to be taxed as an S Corp, which is also referred to as a special small business tax status election. In order to elect to be taxed in this manner, you will need to file Form 2553 (S Election Form) with the Internal Revenue Service (IRS) after the business is formed.
Keep in mind that S Corps are taxed as pass-through entities. This means that the profits and losses aren’t reported by the S Corp but are instead reported on the shareholder’s personal income tax returns. However, the S Corp must still file an informational tax return by filling out Form 1120s. Additionally, the business must also submit K-1 schedules, which report each shareholder’s income from the business.
Some, if not all shareholders in an S Corp can be employed by the business and pay themselves a reasonable compensation for the work done. Once you’ve elected to be taxed as an S Corp, the status will last for five years, after which point you must submit another form to continue being taxed as a small business corporation.
Key Features of a Corporation
Whether you operate an S or general C Corp, corporations have some typical key features, which is important to know before you choose to incorporate your business. First and foremost, corporations offer limited liability, meaning that the shareholders, officers, and board of directors are usually not personally liable for the business’s debts and obligations. The corporation has a perpetual existence, unlike the LLC. This means that the corporation will continue to operate even if someone leaves the business or dies.
The shareholders choose a board of directors who manage the business. The shareholders have various rights, including the right to:
- Elect the directors
- Inspect corporate records
- Vote on important decisions of the business
- Receive distributions
However, the shareholders will not have oversight over the daily operations of the business, as is the case with most LLC owners if they choose to operate a member-managed LLC. Corporations must maintain meeting minutes from all meetings held. Such meeting minutes should be signed by the directors and kept on file.
Compensation vs. Dividends
S Corps can pay dividends to their shareholders, which aren’t taxed as is the case with C Corporations. Therefore, Social Security and Medicare taxes are not paid on dividends. However, if a shareholder in an S Corp also does substantial work for the business, then they are also considered an employee and must pay themselves a reasonable salary. But what constitutes reasonable?
While there are several factors that you can consider when determining the appropriate amount to pay yourself in wages, remember that you cannot simply pay yourself through dividends in an attempt to avoid paying taxes altogether.
Generally, shareholder-employees in an S Corp will wait for profits to be above $50,000 annually before converting back to a C Corp.
For example, if you make $100,000 annually in profit, and pay yourself a $75,000 salary, then the remaining $25,000 would be paid to you in the form if a dividend. You’ll save $25,000 in taxes, but pay taxes on the $75,000 compensation. At some point, it makes more sense to operate as a C Corp, particularly if you have several employees with a very high profit.
The IRS imposes some restrictions on S Corps, particularly when it comes to ownership. The following are those restrictions identified by the IRS:
- The S Corp cannot have more than 100 shareholders, and can only issue one class of stock.
- Shareholders must be natural persons, individual trusts, and/or tax exempt nonprofit organizations. Therefore, any other business structure, i.e. LLC or Corporation, cannot act as a shareholder in the S Corp. Nor can financial institutions or insurance companies act are shareholders.
- The shareholders must be citizens or resident aliens of the U.S.
- After all shareholders are chosen, they all must agree to the S Corp tax status.
If you need help learning more about S Corps or how to form an S Corp, 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.