What’s an S Corporation is an important question to ask for any business owner wanting to incorporate his or her business. An S Corp, like any corporation, is formed by filing the Articles of Incorporation with the Secretary of State’s office in that respective state.

The corporation issues stock and employs a board of directors, officers, and shareholders who oversee the corporation. The shareholders hire the board of directors who will oversee the business. In turn, the directors hire officers who assist in the daily operations of the business.

The shareholders, who are also the owners, have limited liability protection. Therefore, any debts and obligations of the corporation cannot be satisfied by taking the shareholders’ personal assets, such as their homes, personal bank accounts, cars, etc.

For tax purposes, the S Corporation passes through all of its profits and losses to the shareholders, who report it on their personal tax returns. This means that the S Corp doesn’t face double-taxation, as is the case with C Corporations.

Based on these characteristics, the S Corp operates as a hybrid between a C Corp, sole proprietorship, partnership, and LLC.

Criteria for Becoming an S Corp

Keep in mind that some states do not recognize S Corps for tax purposes, particularly New York and New Jersey. But for those states that do in fact recognize S Corporations, the business itself must meet all of the requirements set forth by the IRS to be treated as an S Corp, and this includes:

• The business must have only one class of stock

• There can be no more than 100 shareholders

• All shareholders must be either U.S. citizens or U.S. permanent residents

• All shareholders must be natural persons; other businesses cannot be shareholders

• Profits/losses must be allocated to the shareholders for tax purposes

Advantages of an S Corp

There are several advantages to operating as an S Corp. As previously noted, the shareholders assets are protected, which means that any creditors cannot go after personal assets to satisfy the debts and obligations of the S Corp. This is not the case in a sole proprietorship or general partnership, as personal assets are generally not protected.

Furthermore, the S Corp operates as a pass-through tax entity, meaning that the S Corp doesn’t pay federal income taxes at the corporate level. Instead, as previously mentioned, the profits and losses flow to the shareholders who will report it on their personal income tax returns.

Another significant advantage of an S Corp is the fact that the shareholders can also act as employees of the business and pay themselves a reasonable salary for the work done. In addition, shareholder-employees can receive tax-free dividends from the S Corp, as well as other distributions. This can help such employees reduce their self-employment tax liability, as they will only need to pay taxes on the compensation paid to them and not distributions earned.

Another benefit is the transfer of ownership. Some business structures, including a partnership or LLC, automatically terminate if an owner leaves the business. However, a corporation will continue to exist even if one of the shareholder’s transfers his or her ownership interest.

Furthermore, the S Corp will not need to comply with any accounting rules if the ownership is transferred to another shareholder. Corporations must generally use a cash method of accounting, unless they operate as an S Corp. However, if the S Corp has inventory, then it might still need to utilize the accrual method.

S Corps provide greater credibility with potential customers, employees, business vendors, and financial institutions for lending purposes. S Corps also benefit from less corporate formalities, as S Corps only need to file tax documents once a year, whereas C Corporations must file tax documents on a quarterly basis. This is because C Corps have greater gross receipts.

S Corps, just like any corporation, can provide investment opportunities by selling shares of stock to the public. However, keep in mind that the S Corp can have only one class of stock, whereas the C Corp can offer different classes of stock.

If you need help learning more about an S Corp, or need assistance forming your S Corp, 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.