Your business structure determines how much you pay in taxes and what creditors can come after. Your ability to raise capital depends largely on how you set up your company. An S corporation status is a popular choice for entrepreneurs who want to avoid double taxation and personal liability for business debts but may not yet require an accumulation of funds for expansion. Understanding the benefits and drawbacks of incorporation can help you decide if it’s right for your business.
What Is an S Corporation?
An S corporation is a company that opts to be taxed under Subchapter S of the Internal Revenue Code. Technically, an S corp is not a business entity but a method of choosing how you want your business income to be taxed. This election makes the business a “pass-through” entity for tax purposes. Filing as an S corporation helps entrepreneurs avoid the C corporation’s double jeopardy of having revenues taxed at the corporate rate and then taxed again as personal income.
Advantages of an S Corporation
Perpetuity
As a distinct entity, an S corporation has an unlimited lifespan. An owner’s retirement or death doesn’t impact a business’s ability to continue from a legal standpoint. This type of corporation can also go on if any of the shareholders sell their shares or leave the company.
Asset Protection
A major advantage of S corporation status is that its owner or owners enjoy limited protection from the company’s liabilities, debts and obligations. The owner is only liable to the extent of their investment in the business. A creditor or lawsuit cannot pursue the owner’s personal assets to settle debts or liabilities incurred by the business. Likewise, a personal creditor or lawsuit cannot come after the company’s assets to compensate for the personal debt or liability of the owner.
Tax Treatment
S corporation owners with no inventory can use the cash method of accounting. The cash method makes income taxable when received and expenses become deductible when paid. This is less complicated than the accrual method.
Generally, an S corporation’s revenue is taxed as the shareholders’ personal income. Sometimes, though, an S corporation may still be liable for taxes on certain income. Form 1120S, U.S. Income Tax Return for an S Corporation, provides details.
S Corporation vs. C Corporation
An S corporation is quite similar to a C corporation. With this status, the company itself is not taxed like C corporations. The S corporation’s shareholders receive the company’s profits and pay income tax at individual rates.
- limited liability
- officers
- shareholders
- records and minutes
- s corp files a form with the IRS to be treated as an s corp
S Corporation vs. LLC
An S corporation shares the benefits of pass-through taxation and limited liability with an LLC or limited liability corporation. S corps and LLCs differ vastly in who can be a shareholder and their profit distribution. An LLC may be subject to a self-employment tax that increases with income. Its stocks are not freely transferable. Further, an LLC typically has a limited life span.
Disadvantages
Some business owners may find that S corporation status doesn’t suit their situation. The limitation of issuing only common stocks may hinder some efforts to raise capital. S corps may incur higher tax service and legal costs with annual filings and corporation protocols.
Requirements
An S corporation has to meet specific requirements in the Internal Revenue Code. It has to:
- Be a domestic corporation
- Have one class of stock
- Have no more than 100 shareholders
Shareholders may be individuals, certain trusts and estates and exempt organizations. Spouses count as one shareholder. Shareholders cannot be corporations, partnerships or nonresident aliens. Domestic international sales corporations, insurance companies and certain financial institutions are not eligible for S corporation status.
Filing with the State
A business owner electing S corporation status must submit articles of incorporation with the Secretary of State in the state or states where the business operates. The state will mandate an annual shareholder’s meeting and annual filing. The company must have a registered agent and a registered office; this requirement ensures that the state knows where to send official notices.
Hiring a Registered Agent
Most small business owners appoint themselves to be their own registered agent. However, some entrepreneurs choose to hire registered agent services for these reasons:
- To delegate annual filings and keep track of notices
- To avoid listing a home address as a business point of contact on public records
- To designate someone to accept official notices during normal business hours
Making the Election
After filing with the state, an eligible business entity must submit IRS Form 2553, Election by a Small Business Corporation. The company must complete it:
- No later than two months and 15 days after the beginning of the tax year in which the election is effective
- At any time during the tax year prior to the tax year in which the election takes effect
The original form can be mailed or faxed to the IRS. It’s not necessary to file every year. A corporation can request relief for a late election if it meets certain requirements and has a reasonable cause for failing to file promptly.
Revoking Status
Business owners and shareholders may decide to terminate their S corporation status, and they will need to meet and gain the consent of over 50% of the owners in a vote. This must be recorded in the meeting minutes; the majority will sign a consent form and send it to the IRS. The timing of the revocation affects how the company is taxed, so discuss this potential change with an accountant.
Final Considerations
The states differ in how they treat S corporations. Some do not offer any tax breaks, while others automatically honor the IRS election. Consult a legal professional or accountant in your state regarding the specifics for your business.
If the IRS does not approve your election, you will receive a CP264 Notice explaining why. If you still want your business treated as an S corporation, you’ll need to file a new Form 2253. You can resubmit the form at any time.
