S Corporation: Everything You Need to Know
An S Corporation is a particular type of company that enables the safety of limited liability but directs flow-through of income and losses.4 min read
What Is an S Corporation?
An S corporation is a type of company that provides a lot of personal protection while also streamlining the flow of income and losses. Many small businesses desire the S corp designation because of the numerous tax benefits and protection that it comes with.
Companies with the S corporation designation are afforded a unique tax break. Rather than paying federal taxes at the corporate and individual level, S corps can pass revenues and losses all the way to the shareholders to be included on their tax return.
Companies must pass certain tests in order to receive the S designation. For instance, a company cannot have more than 75 shareholders, with spouses counting as one shareholder. Additionally, S corps can have the following designated as shareholders within the company.
- Estates and trusts
- Specific partner designations
- Tax-exempt charities
- Another S corp (designated as a single shareholder)
S corporations can also use cash accounting instead of the typical accrual model, but only if the corporation does not have inventory. The cash method for accounting purposes allows income to be taxed upon receipt and expenses deducted when paid.
There are some disadvantages to receiving an S corp designation. For instance, as an S corporation you would need to follow the same guidelines of other corporations, which means increased legal and tax fees when needed.
You would also be required to:
- File incorporation articles
- Conduct frequent shareholder meetings
- Maintain company minutes
- Have votes on specific decisions relevant to the corporation
The cost of organizing an S corporation are also just like those for a standard company. S corps can only issue common stock, which can hamper capital-raising efforts. Subchapter S designation requires all shareholders to provide approval.
States deal with S corps differently. Some states do not recognize the subchapter S designation, which eliminates any of the associated tax benefits. Other states honor the federal election automatically. An S corporation might have its subchapter S standing revoked by either failing to satisfy the conditions of eligibility for S corps, or by filing with the IRS no later than two months and 15 days after the first day of the taxable year. A company is subject to being taxed as a corporation as soon as the revocation becomes effective.
Many business owners have a hard time deciding between a limited liability company and an S corporation because of their similarities. S corps and LLCs are both pass-through taxation entities, which allows business revenue and losses to trickle down to the personal income tax return of the owners. This can be a major benefit for business owners, as it removes the possibility of double taxation. Both designations also provide individual asset protection and limited liability in the event that the company’s assets need to be dissolved. However, there are some differences between LLC and S corps, the biggest being the number of shareholders allowed for each and the residency requirements of owners.
The Similarities Between S Corporations and C Corporations
The designation of a C corp is the most basic corporation, whereas the S designation has a unique tax status with the Internal Revenue Service (IRS). In fact, the name “S” is derived from the IRS’ Internal Revenue Code for the Subchapter S.
To designate an S corp standing when forming a company, you’ll need to make sure you qualify and then file a form 2553 directly with the IRS. Even though the S and C designation are different, they do share some similarities such as the limited liability protective nature of each corporation, the documents that must be filed are the same regardless of the designation, and the corporate structure with shareholders and officers are uniform.
The Differences Between S Corporations and C Corporations
While there are some similarities, there are also differences between C and S corporations. The main differences revolve around tax. C corps are individually taxable entities, so C corps must file as separate tax entities. The tax return Form 1120 is required.
C corporations may also face double taxation if company income is distributed to business owners as payments that are considered private revenue. In a C company, taxes are paid at the corporate level on the revenue and then again on the shareholder’s dividend payouts. On the other hand, S corps do not have to pay corporate taxes and must submit a Form 1120S for the tax return.
Advantages of S Corporations
The major benefit of the S corporation designation is that shareholders are only required to pay taxes on their salaries and not on the self-employment tax for their firm’s profits. In an S corporation, before any profits can be had, every owner who also works as an employee should be paid a reasonable amount for their efforts (e.g., wage). This wage is subject to Social Security and Medicare taxes, which should be paid partially by the employee and the other part by the company. The financial savings from paying no self-employment tax on the profits kicks in as soon as the S corp has sufficient income that there are profits left to be paid out after paying the necessary reasonable wage.
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