What is subchapter S corporation? An S corp is a corporate entity with an S tax code classification from the IRS. It is not a legal entity, but a tax-based classification that the IRS gives to business owners who request the designation.

The tax code allows business income and losses to pass from the business to individual shareholders without paying business income taxes. Shareholders may then report business losses and income on their individual tax returns and would pay the taxes owed. The main attribute that separates an S corp from a C corp is that S corps do not pay business income taxes.

S corps tend to be a more attractive option for small owners than a standard C corp. However, a corporation must meet certain criteria before obtaining S classification status:

  • Must be a domestic corporation
  • Cannot have over 100 shareholders
  • Are restricted to one stock class (No tiered stock permitted)
  • Cannot be owned by non-residents and non-U.S. citizens
  • Other entities cannot own an S corp, such as other corporations or LLCs

S Corp Benefits

Like C corps, an S corp offers the following benefits:

  • Limited Liability Protection: S corp shareholders receive certain liability protections as they conduct business. For instance, they cannot be held liable for any liabilities or debts that a business incurs, and creditors cannot gain access to personal property in the form of houses or cars to satisfy business debts. Liability is only restricted to the amount a shareholder has invested in the company.
  • Pass-through Taxation: Pass-through taxation allows shareholders to save money and avoid paying business income taxes.
  • Income Offsets: If you juggle multiple income streams, any losses from the S corp may be used to offset a portion of other income sources.
  • Estate-Planning: S corps aid in transferring property or other assets to heirs upon your death.
  • Perpetual Existence: S corps exist forever, even if you are a sole-owner, or if owners leave or die.
  • Ownership Transfer: Owners may transfer shares without facing tax ramifications or entity dissolution. On the other hand, LLC owners risk dissolution if they transfer more than 50 percent interest to another party. Additionally, an S corp does not have to adjust property basis or adhere to complicated accounting measures. S corp owners with inventory may use the cash accounting method, which is an easier accounting measure when compared to the accrual method.
  • Heightened Credibility: The public views S corps with more credibility than other business entities. This is because it shows that owners have made a sound commitment to their business. Your business is more likely to attract additional customers, employees, and suppliers under an S corp.

S Corp Taxation

Shareholders can save additional taxes if they work as employees. An employee classification helps shareholders save money on self-employment taxes.  For example, a shareholder who does extra work for a company may designate his or herself as an employee and take a salary. In addition, they can accept tax-free distributions or dividends while accepting the salary. Moreover, they can generate wage-paid and business-expense deductions.

S Corp Basics

When creating an S corp, you need to remember the following:

  • Articles of incorporation
  • Recording corporate minutes
  • Conducting shareholder and directors meetings
  • Establishing voting procedures

The added paperwork and flings may include:

  • Employ Tax Documents
  • Form 1040 (Individual Income Taxes)
  • Form 1040 (Estimated Individual Taxes)
  • Forms 940, 941, and 2553
  • Form 4625 (Depreciation)
  • Schedule K-1 (Income, Deductions, and Credits)

Potential Consequences

Be aware that you may need additional paperwork, and you should consult with an accountant or attorney to know more about what may be required of your business. By failing to file the necessary paperwork, your S corp status may be worked. If this occurs, your business will be taxed as a C corp.

You should also know that the IRS tends to scrutinize S corp income characterizations due to the potential for abuse. This is why you should adequately characterize your income in the proper manner to avoid a response from the IRS.

For example, if you are shareholder who chooses to be classified as an employee, you should be paid what’s considered a reasonable salary based on the job position you’re filling. Making your salary artificially low could trigger an IRS response because it appears you’re trying to get out of paying additional self-employment taxes.

What is subchapter S corporation? To learn more, submit your legal inquiry to our UpCounsel marketplace. UpCounsel’s attorneys will give you additional insight into S corp essentials, and whether an S corp classification would be the right fit for your business. Moreover, they will help you maintain your organization, especially if you have never created or maintained a corporation before.