What is an S corporation status? An S corporation status is a type of federal tax treatment available to some C corporations and LLCs that enables them to operate without paying corporate tax. The S corporation gains pass-through tax status without losing the other privileges that C corporations have. Corporations that have less than 100 U.S. shareholders can request S corporation status by filing Form 2553 with the IRS.

S Corporation Status: Why Do Some Business Want It?

Congress introduced the S corporation tax treatment in 1958 to reduce the tax burden on small corporations. S corporation tax treatment gives corporations pass-through status, and hence, any profits they make are not taxed by the IRS. However, they are passed through to the individual shareholders. The shareholders must pay personal income tax at the standard rates on their share of the corporation's earnings.

S Corporation Tax Status: How Do You Get It?

S corporation tax treatment can be given to small corporations and some LLCs. The corporation must form the normal way. This usually involves the following steps:

  • Booking a name from the secretary of state.
  • Appointing a registered agent for service process. The registered agent receives legal papers on behalf of the corporation.
  • Appointing directors. The directors give oversight to the management of the corporation.
  • Filing the articles of incorporation. This document is normally submitted to the secretary of state where the corporation is registering. The document states basic facts about the corporation. Acceptance of this document by the secretary of state signals the official formation of the corporation.
  • The corporation must then hold a board of directors meeting. The directors will adopt corporate bylaws, appoint managers of the corporation, and initiate stock issuance.
  • The corporation then issues stock certificates to shareholders.
  • The corporation can then get an EIN from the IRS, as well as the relevant local, state, and federal government permits and licenses.

After getting the EIN, the corporation can apply for S corp treatment to the IRS. The Election by a Small Business Corporation, Form 2553, was designed for this purpose. The form requires the following details:

  • The name of the corporation.
  • The EIN of the corporation.
  • Details about the tax year the corporation will follow.
  • The effective date of S corp treatment.

It is important for the corporation to apply for S corp treatment in the first two months and 15 days of the S corporation's tax year. Otherwise, S corp treatment cannot be given for that tax year.

How the IRS Handles S Corporation Tax Issues

S corporations are required to file income tax returns with the IRS. They do this using Form 1120S. S corporations do not pay corporate tax for this return, but the form helps to inform the IRS about the S corporation's income. The corporation must also attach each shareholder's Schedule K-1. Schedule K-1 lists each shareholder's share of earnings from the S corporation. These forms help the IRS when verifying the personal income taxes of the corporation's shareholders.

The S corp shareholders must pay personal income tax on their share of the S corporation's earnings. A shareholder files personal income tax from the S corporation using Schedule K-1s obtained from the S corporation when he or she is filing Form 1040.

How States Treat S Corporations

States differ in their approach towards S corporation taxes. While some states take cues from the IRS and give S corporations pass-through status, other states require S corporations to pay state corporate tax.

Some states also require S corporation shareholders to pay additional income tax to the state. In addition, most states require S corporations to pay the other state taxes that C corporations pay. These taxes include:

  • Sales tax
  • Franchise tax
  • Excise tax
  • Unemployment tax
  • Workers' compensation tax.

S Corporation Status: How It is Terminated

The corporation can terminate its S corporation status any time. To terminate S corp treatment, a corporation files a statement of consent by the shareholders expressing their desire to revoke S corporation treatment.

The IRS can also terminate a corporation's S corporation treatment if it breaks any of the laws for S corps. If that happens, the IRS may even impose a penalty and require the corporation to pay three years' worth of taxes.

S corporation owners should think carefully before terminating S corp treatment because once it is terminated, the S corp will not qualify for S corporation treatment again for another five years.

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