S Corporation Form: Everything You Need to Know
An S corporation form is needed to convert your existing business into an S corporation or to form a new one. 3 min read
2. Disadvantages of S Corporations
3. Does Your Business Qualify as an S Corporation?
4. How to Form an S Corporation
An S corporation form is needed to convert your existing business into an S corporation or to form a new one. An S-Corp has tax advantages that might benefit your business. It also offers flexibility regarding business ownership.
Congress enacted a law in 1958 allowing the formation of S corporations, which are more formally known as subchapter S or small business corporations. Its intention was to support the development of small businesses, many of which are family-owned, and also eliminate the double taxation that applies to regular corporations.
The S corporation is a legal entity separate from its owners. Owners are referred to as shareholders. This is an election you make with the IRS. It allows your business to be taxed in a similar way to a partnership instead of a C corporation. While C corporations are treated as taxpayers in their own right and must file their own returns, S corporations allow the profits, losses, deductions, and credits to pass through to the partners or shareholders. This means only the shareholders, and not the corporation, get taxed.
Advantages of S Corporations
- S corporations do not pay federal income tax, with the exception of some forms of passive income and capital gains.
- An S corporation is similar to an LLC in that it lets profit pass through to its owners so income is only taxed on the shareholders' individual returns. This avoids double taxation on profits.
- S corporations protect owners' personal assets because they are kept separate from business assets. Shareholders are not responsible for the company's debts or legal liabilities, so creditors cannot seize personal assets to pay business debts.
- S corporation owners have flexibility in how they handle their income. They can designate themselves as employees that are paid a salary. They can also receive dividends, which are taxed at a lower rate than that of an employee salary. As long as this is done in a reasonable manner, it can reduce the amount of taxes shareholders pay. However, you cannot use an unreasonably low salary to protect yourself against self-employment taxes.
- S corporation ownership is easy to transfer to new owners. Doing so does not require complicated accounting or result in tax penalties.
Disadvantages of S Corporations
Unlike C corporations, S corporations have restrictions on their ownership structure. They can only offer one class of stock, which makes them less attractive to investors. They must also have no more than 100 shareholders, and shares cannot be owned by foreign investors, trusts, or other corporations.
S corporations offer flexibility and potential tax savings because shareholders can classify income as either wages or dividends. In some cases, however, this can cause problems. The IRS monitors business owners to make sure they're not inaccurately categorizing income as dividends instead of wages.
S corporation owners might make mistakes on their IRS filings, which typically involve stock ownership, notification, consent, and other administrative concerns. This could cause the company to lose its S corporation status.
Does Your Business Qualify as an S Corporation?
Businesses must meet IRS requirements to qualify for S corporation status, including the following:
- S corporation shareholders are restricted to individuals, certain trusts, or estates. They cannot include partnerships, other corporations, or nonresident alien investors.
- S corporations are restricted to 100 shareholders.
- S corporations can only issue one class of stock.
- Some corporations, such as financial institutions, international sales corporations, and insurance companies, are ineligible for S corporation status.
How to Form an S Corporation
The steps to form an S corporation are as follows:
- First, you must form a C corporation.
- The C corporation owners must file Form 2553, in which they elect status as an S-Corp.
- According to IRS rules, the election form must be filed at the beginning of the business' tax year and no more than two months and 15 days after.
- You must wait to find out if the IRS accepts the election, at which point you will be notified in writing.
Filing an S-Corp election form does not require a fee. Local and state agencies might require other forms.
If you need more information or help with an S corporation form, 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.