S Status for Businesses: Tax Benefits & Rules

Key Takeaways

• S status is a tax election allowing small businesses to avoid double taxation.
• S corporations offer pass-through taxation, limited liability, and lower self-employment tax.
• Electing S status involves strict eligibility criteria including limits on shareholders and stock classes.
• LLCs can also elect S status by first filing as a corporation.
• Missteps in maintaining compliance can result in termination of S status.
• Certain businesses and industries may not benefit from electing S status due to restrictions and tax consequences.
• Timely IRS filing (Form 2553) is essential for establishing S corporation status.
• UpCounsel can help connect you with experienced attorneys to ensure your S corporation election is handled properly.

What Is an S Corporation?

S corporation status is a business entity election that will determine how the business is taxed as well as how it will be organized. When a business meets the eligibility requirements, they can elect their S corporation status with the IRS. 

An S corporation is also known as a subchapter or a small business corporation. This tax status was incorporated into the tax code by Congress in 1958. Companies that elect the small business or S corporation status can take advantage of multiple benefits including:

• Limited liability for the owners
• Single tier taxation
• Perpetual existence
• Annual tax filings

When a corporation is formed, they are automatically considered a C corporation. After being established as a C corporation, you can then file for S corporation status once you have met all of the requirements. For example, S corporations are owned by shareholders who then elect directors to manage the corporation's day-to-day operations.

The S corporation status was created to provide the same protections as a partnership without double taxation. S corporation status is great for small, domestic companies since S corporations have a limit of 100 stockholders. Large corporations who are looking for overseas investors should elect C corporation status as there are no restrictions on ownership or size.

Eligibility Requirements for Electing S Status

To elect S status, your business must meet specific IRS eligibility requirements. These rules ensure that the entity maintains its small business orientation:

• Be a domestic corporation or a limited liability company (LLC) that elects to be taxed as a corporation.
• Have only allowable shareholders, which include individuals, certain trusts, and estates (not partnerships or corporations).
• Not have more than 100 shareholders.
• Have only one class of stock (differences in voting rights are permitted).
• Use a permissible tax year, typically ending December 31, unless a valid business purpose is demonstrated.

Failure to meet any of these criteria can disqualify a business from maintaining its S status.

The Advantages of S Corporations

There are many advantages to electing S corporation status. Some of the major benefits that business owners consider when making the choice are:

• Limited liability for directors, officers, shareholders, and employees.
• Pass-through taxation--Business profits are only taxed at the individual level after distribution, not at the corporate level.
• Investment opportunities--S corporations can sell ownership in the company as stock or shares.
• Freely transferable stock
• Perpetual existence--In the event of the death or departure of an owner, the business will continue to exist.
• Reduced self-employment taxes--When you own a sole proprietorship or are part of a partnership, you will be required to pay self-employment taxes, including Social Security and Medicare on the total profits. However, if you structure your business as an S corporation, the business will withhold some of the pay to take care of Medicaid and Social Security.
• Flexible management structure
• Flexible characterization of income--income for employees and owners can be marked as dividends, distributions, or salary.

Additional Tax Advantages and Considerations

Beyond the basic pass-through taxation, there are nuanced tax benefits to consider:

• Avoidance of Double Taxation: Unlike C corporations, profits are taxed only at the individual level, not the corporate level.
• Qualified Business Income (QBI) Deduction: Shareholders may be eligible for up to a 20% deduction on qualified income, depending on income thresholds.
• Favorable Treatment of Basis: Shareholders may increase their stock basis through retained earnings, allowing for future tax-free distributions.
• Payroll Tax Minimization: By paying reasonable salaries and taking the rest as distributions, S corporation shareholders can potentially reduce payroll tax liabilities, though the IRS closely monitors this.

These benefits are best evaluated with legal or tax advice to ensure compliance and optimization of tax savings.

Disadvantages of an S Corporation

While there are many advantages to electing an S corporation status for your business, there are also some disadvantages that you should consider before making your decision. Some of the disadvantages of an S corporation structure include:

• Ownership is restricted to United States citizens.
• The corporation cannot have more than 100 shareholders.
• Only individuals, certain trusts, and estates can be shareholders.
• There are costs for formation as well as ongoing fees for maintaining your status.
• Tax mistakes can easily lead to the cancelation of the S corporation election.
• The IRS may more carefully scrutinize related tax returns since owners have the choice in how they choose to have their income taxed.
• The company must be a domestic company with domestic investors.
• They may only offer one class of stock (with the exception of voting and non-voting stock).
• They must use December 31st as their year-end for tax purposes.

Risk of Inadvertent Termination of S Status

One critical risk of S status is inadvertent termination. If the business violates IRS requirements, the S election can be revoked automatically. Common causes include:

• Accepting an ineligible shareholder (such as a corporation or foreign individual).
• Issuing a second class of stock, intentionally or by mistake.
• Exceeding the 100-shareholder limit due to stock transfers or inheritance.
• Failure to maintain proper records and adhere to formalities.

If termination occurs, the business may revert to C corporation status, which can lead to double taxation and other negative tax consequences. Proactive compliance and legal oversight are essential.

How to Start and Form an S Corp

When forming an S corporation, there are multiple steps that you will be required to complete.

1. Decide on your legal business name and reserve it with the Secretary of State office.
2. Decide on a registered agent to accept legal forms on behalf of the company. He or she must be available during business hours and have a physical address where they can receive legal summonses if necessary.
3. File your Articles of Incorporation with your Secretary of State's office.
4. Complete your corporate bylaws and create a summary of the company rules that affect the operations as well as the officers and their duties.
5. Issue stock to your initial company stockholders.
6. Apply for any business licenses you will need to operate.
7. Obtain an Employer Identification Number from the Internal Revenue Service.
8. Secure any other necessary federal, state, and local business ID numbers that you will need to operate.
9. File the IRS Form 2553

Maintaining Compliance With S Status Rules

Once an S corporation is formed, ongoing compliance is essential to retain the election:

• File annual tax returns using Form 1120S.
• Issue K-1s to shareholders detailing their share of income, losses, and credits.
• Maintain accurate records and corporate formalities, including meeting minutes and bylaws.
• Monitor ownership changes to ensure all shareholders remain eligible.
• Avoid creating multiple classes of stock inadvertently (e.g., through varying distribution rights).

Failing to comply with these requirements can trigger IRS audits or loss of S status.

How LLCs Can Elect S Corporation Status

An LLC can choose to be taxed as an S corporation by following a two-step process:

1. Elect to be Taxed as a Corporation: File IRS Form 8832 (Entity Classification Election) to be taxed as a corporation.
2. Elect S Corporation Status: File IRS Form 2553 to elect S status within 75 days of formation or by March 15 of the tax year.

This election is often used to minimize self-employment taxes, but the LLC must then comply with all corporate formalities, including maintaining bylaws, issuing shares, and holding annual meetings.

Frequently Asked Questions

1. What does electing S status mean?
   It means a business chooses to be taxed as an S corporation, allowing income to pass through to shareholders without corporate taxation.
2. Can an LLC elect S status?
   Yes. An LLC can first elect to be taxed as a corporation using IRS Form 8832, then file Form 2553 to elect S corporation status.
3. How long does it take for S status to become effective?
   If Form 2553 is filed within 75 days of formation or by March 15 of the tax year, S status can take effect that same tax year.
4. What happens if an S corporation has more than 100 shareholders?
   It becomes ineligible for S status and may be treated as a C corporation, losing pass-through taxation benefits.
5. Can foreign individuals own stock in an S corporation?
   No. Only U.S. citizens and certain residents may be shareholders in an S corporation.

If you need help determining if S corporation status is right for your business, 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.