1. What is an S Corporation?
2. Pros and Cons of an S Corporation
3. The Major Difference Between a Traditional Corporation and an S Corporation
4. Electing an S Corporation Status
5. Passive Income Caution
6. S Corporation vs. LLC

S corporation companies are business entities that function similar to corporations but are taxed like partnerships. Find out everything you need to know about S corporations and how they differ from C corporations to decide which is right for your business.

What is an S Corporation?

An S corporation elects to use the subchapter S taxation of the Internal Revenue Code. It becomes a pass-through entity for tax purposes but still reaps the benefits of having a corporate structure. Taxes, deductions, corporate income, and losses pass through to shareholders as part of their personal income taxes. The amount they pay is proportionate to their ownership or investment in the business, whether the income is distributed or not. As a result, individual shareholders earn larger distributions of the business income.

Pros and Cons of an S Corporation

There are a number or benefits to starting an S corporation over a C corporation. Some of the pros include:

  • Avoiding double taxation by paying profits to shareholders instead of paying taxes through the corporation
  • Providing liability protection for shareholders who want to keep their personal assets separate from business assets to prevent personal lawsuits or debts from impacting the corporation 
  • Increasing investment opportunities by having a maximum of 75 to 100 shareholders, depending on the state where you formed the corporation
  • Using the simpler cash method of accounting instead of the accrual method if the corporation does not have any inventory
  • Writing off shareholder business expenses, such as health insurance, in certain cases as advised by a professional accountant or tax professional

In addition to their many benefits, there are some disadvantages to S corporations. They include:

  • Not being recognized as a business type in some states
  • Filing state and federal documents, such as corporate minutes and Articles of Incorporation, and paying certain fees
  • Holding regular shareholder meetings 
  • Issuing a single class of stocks
  • Paying income taxes on the total income of the business even if there is no payout
  • Paying all owners and officers reasonable salaries based on open market wages for certain skill sets, whether or not the business earns a profit

The Major Difference Between a Traditional Corporation and an S Corporation

The major differences between S and traditional C corporations relate to taxation. S corporations do not pay corporate taxes. This is a big advantage since C corporations pay tax on business income at the corporate level, and shareholders pay personal income tax on residual income distributed by the corporation. Another key difference between S and C corporations is that C corporations pay the 15-percent federal tax rate on dividends, while S corporations pay the shareholders' marginal tax rates on distributions.

Electing an S Corporation Status

To create an S corporation, the business must first incorporate as a C corporation and file Internal Revenue Service (IRS) Form 2553 in the state where it was incorporated. If Dec. 31 is not the year-end tax date for your corporation, you will need to first file for permission from the IRS to elect S status.

Recently incorporated businesses can file for S status at any time in the tax year within 75 days of their incorporation date. After 75 days, you can still change your corporation status. However, for calendar-year taxpayers, the election must take place before March 15 for it to take effect in the current year.

Passive Income Caution

Stocks, bonds, equity-type investments, and real estate are examples of passive income. The IRS can revoke your S status if your passive income is more than 25 percent of your gross receipts over a three-year timeframe. If your corporation is likely to have a large passive income, consider forming a limited liability company (LLC) instead. 

S Corporation vs. LLC

In some cases, an LLC is a better choice than S status. LLCs can have unlimited members, including other LLCs, partnerships, and trusts. In addition, all S corporation shareholders must be U.S. citizens or permanent residents. LLCs are open to ownership by non-U.S. citizens and nonresident aliens. 

Another benefit of an LLC over S status is that LLCs offer provisions to protect individuals from losing their membership stakes if involved in personal lawsuits. S corporation members facing similar situations risk having their shares seized as assets.

There are many advantages and disadvantages to setting up an S corporation company. Knowing what they are can help you make the best choice for your business. 

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