S Corp Formation: Everything You Need to Know
S corp formation refers to the election of S corporation status by a business organization3 min read
S corp formation refers to the election of S corporation status by a business organization. An S corporation (S corp) is a hybrid business structure that combines the liability protection of a corporation with the pass-through taxation of a partnership or a limited liability company. The requirements for forming an S corporation may vary from one state to another, but they generally include certain standard procedures.
What Is an S Corporation?
An S corporation is a corporation that has elected S corp tax status. This type of corporation protects its owners from personal liability while enabling them to pay income taxes at the individual level and avoid the double taxation issue experienced by an ordinary corporation.
An S corp is a small corporation that chooses to pay taxes in accordance with Subchapter S of the Internal Revenue Code. This allows it to gain some, but not all, of a partnership's tax benefits. An S corporation is not required to pay taxes at the corporate level. Instead, it files an informational tax return and passes its income or loss through to its owners' personal tax returns.
How to Elect S Corporation Status
To qualify for S corporation status, your company must meet the following criteria:
- Have one to 100 shareholders.
- Have consent for an S corp election from all shareholders.
- Have shareholders that are individuals or certain estates or trusts, but not nonresidents, partnerships, or corporations.
- Have no more than one class of stock.
- Adopt an acceptable tax year.
- Must not be a financial institution using the Section 585 reserve method of accounting for bad debts, an insurance company paying taxes under Subchapter L, possessions corporation, or an existing or former domestic international sales corporation (DISC).
If any of these requirements are not met at any time, you will lose your S corporation tax status and revert to the less favorable tax status of a normal corporation.
To form an S corporation, you are required to complete the following procedures:
- Select a business name and make sure it is not already taken by another business in your state.
- Submit the Article of Incorporation to the secretary of state.
- Establish corporate bylaws if required in your state.
- Keep minutes of all shareholder and board meetings.
- Obtain an Employer Identification Number (EIN) by filing IRS Form SS-4.
- Apply for state and local permits if required.
Submission of Form 2553
After forming your corporation, you need to complete and submit Form 2553 to the IRS within two months and 15 days of the start of your chosen tax year or any time within the tax year before your S corporation's first effective tax year. When you are filing Form 2553, you are required to include the following information:
- Name of your corporation
- Address of your corporation
- State where your company is incorporated
- Date of incorporation
- Effective date of S corporation election
- Information about shareholders
- Information about fiscal tax year
- Signatures of all shareholders.
Approval of S Corp Tax Status
After submitting your application for S corp tax status, you will know whether your application is approved or rejected within 60 days of filing. If you have selected a business purpose tax year, it may take an additional 90 days for your application to be processed.
Once your application is approved, your S corp tax status will be effective until it is revoked or terminated. In the event you fail to comply with all the requirements that apply to an S corporation, your company's corporate status and liability protection will be revoked, leaving your personal assets susceptible to seizure.
You must pay a salary to any shareholder who performs work for your S corporation. Your corporation is required to pay and withhold Social Security and Medicare taxes on your employees' wages. However, such taxes are not applicable to distributions to shareholders. Therefore, the more revenue shareholder-employees receive as distributions, the less Social Security and Medicare taxes they need to pay.
Given the potential for abuse, the IRS scrutinizes the salary-distribution allocation of income in S corporations very carefully. When you are allocating income for tax purposes, you have to make sure you allocate a reasonable portion to salary in relation to distributions.
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