S Corps for Dummies: Everything You Need to Know
S corps for dummies may be considered a simplified version of how to elect Subchapter S tax status with the IRS.3 min read
S corps for dummies may be considered a simplified version of how to elect Subchapter S tax status with the IRS. Not all businesses are eligible for this election, and certain restrictions apply. It's a good election for many small businesses. The IRS created the S corp status specifically to encourage the creation of small, domestic companies.
S corporations begin as standard corporations. You can form an S corp by electing a special tax status with the IRS. You file form 2553 with the government.
Taxation and Restrictions
S corps are considered “pass-through” entities, similar to partnerships and sole proprietorships because business income and expenses pass through to company shareholders/owners. Owners then file this information on their personal tax returns.
S corps file their own tax returns on form 1120S (standard corporations file form 1120), and they issue K-1s to their shareholders.
The biggest difference between other business entities and S corps is that in an S corporation, shareholders can also be employees and earn a salary. They're then subject to the same payroll taxes.
S corporations have the following restrictions on eligibility.
- They have a maximum of 100 shareholders.
- Shareholders must be U.S. citizens or resident aliens.
- Shareholders can only be individuals, individual trusts, and tax-exempt nonprofit organizations. LLCs, other corporations or S corporations, and partnerships can't be shareholders.
- They can only issue one class of stock.
- All shareholders have to agree to S corp election.
When deciding whether or not to elect for S corp status, you should carefully consider if that's the best option for your corporation. First, you must meet the guidelines. For instance, foreign shareholders aren't allowed, so your investment opportunities are more limited than a corporation's.
Ask the following questions if you're interested in ways to minimize the overall income tax burden on company shareholders and the corporation.
- As long as the business qualifies to be an S corp, should we choose to pass through company income to shareholders, which generates taxable income?
- Should we continue on as a C corporation and be subject to double taxation, where the business pays income tax and then stockholders pay their share of tax on the dividends they receive?
C Corps and S Corps for a Small Business
Corporations are separate legal entities recognized by the state. Small businesses can operate as C corps or S corps, depending on which structure is most beneficial for the company. By incorporating, you protect shareholders' personal assets from the corporation's debts and obligations.
The ways in which C corps and S corps are similar include the following:
- Limited liability protection: In general, a corporation's directors, officers, and shareholders cannot be held liable for the company's obligations. Creditors cannot come after the owners' home or personal bank accounts to settle debts.
- Perpetual existence: Unlike sole proprietorships and partnerships, corporations may last indefinitely unless they're dissolved. If an owner leaves the company or dies, the business goes on.
- Management: The company's overall management is handled by the board of directors, which the shareholders choose. Directors choose the officers, who tend to the day-to-day operations of the company.
- Shareholder rights: Owners have various rights in the company, including the right to receive information, elect directors, vote on major business decisions, inspect corporate records, and share in distributions.
- Owners: Shareholders are the corporation's owners. They hold stock in the company.
- Formalities: To properly run a corporation, certain formalities must be taken. These include maintaining a corporate records book, completing required government filings, and holding regular shareholder and board of directors meetings.
- Taxes: C corps pay taxes at the corporate level, while S corps do not. Shareholders in an S corp pay taxes at the individual level, which is often lower than the corporate rate. While that's usually an advantage S corps have over C corps, S corp shareholders in high-income tax brackets may end up paying more in taxes if their individual tax rate is very high.
Tax considerations are often a motivating factor in choosing a business structure. Small business owners appreciate avoiding double taxation by electing S corp status. However, as beneficial as this business type is, it's not best for all companies. In some cases, particularly for businesses that wish to expand outside of the country, remaining a traditional C corp is the right decision. Consult with tax and legal professionals if you need help choosing the best business structure for you.
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