S Corporation Status: Everything You Need to Know
S corporation status is a business entity election that will determine how the business is taxed as well as how it will be organized. 3 min read
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.
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.
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.
How to Start and Form an S Corp
When forming an S corporation, there are multiple steps that you will be required to complete.
- Decide on your legal business name and reserve it with the Secretary of State office.
- 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.
- File your Articles of Incorporation with your Secretary of State's office.
- Complete your corporate bylaws and create a summary of the company rules that affect the operations as well as the officers and their duties.
- Issue stock to your initial company stockholders.
- Apply for any business licenses you will need to operate.
- Obtain an Employer Identification Number from the Internal Revenue Service.
- Secure any other necessary federal, state, and local business ID numbers that you will need to operate.
- File the IRS Form 2553
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.