An S corporation, or simply S corp for short, is basically a standard corporation that has elected to be taxed under the S corporation status. Unlike the double-taxation experienced by C corporations, S corps are only taxed once at a personal tax rate. This means that the shareholders, not the corporation itself, are the ones responsible for paying taxes on any income received.
Since S corps are really a tax status, not a type of business formation like a limited liability company (“LLC”), it may be difficult to find a real life example of how successful these types of businesses have fared in the past. In fact, most S corps start out as small businesses and those that are profitable enough eventually end up changing their status to either a corporation or LLC.
In addition, the current trend for small businesses and startups today is to initially begin by forming an LLC. This way the owners will not have to deal with changing the status and extra paperwork in the future. Thus, it appears as if S corps are becoming less popular in modern society.
However, if you are set on filing taxes as an S corp, the following is an example of how an S-Corporation works:
- Five friends start a small business in which they are equal shareholders. After realizing they meet all of the requirements, they decide it would be more advantageous for their business if they filed taxes as an S corp. During the first year, their business only makes $200,000. Since each friend owns one-fifth of the business’s shares, they are each responsible for reporting $40,000 on their personal income tax returns.
Why Create an S Corporation?
The main reason as to why someone would choose to file as an S corporation over a regular corporation is because it offers all of the benefits that a corporate structure has, but without the double taxation issue.
As briefly discussed above, S corps are only taxed once at a personal tax rate. This means that any income, loss, credits, and/or deductions are all reported by the individual shareholders on their personal income taxes.
Corporations, on the other hand, are taxed at both the corporate level and shareholders are taxed again at the individual income tax level. This is why this disadvantage is referred to as “double taxation.”
However, it is important to note that not all S corps get to enjoy this primary advantage since tax laws can vary by jurisdiction. Also, even if an S corp does qualify for exemption from federal income taxes, it may still be subject to federal taxes for passive income and certain capital gains.
What Are Other Benefits of S Corporations?
Despite its dwindling usage, S corps offer shareholders a number of benefits. Aside from avoiding the double taxation issue, some other benefits that S corps provide include:
- Limited personal liability: Unlike C corporations, shareholders cannot be held personally responsible for the debts of the S corp.
- Tax reductions: Since S corp owners are required to pay themselves a salary, the rest of the S corp’s profits will be treated as dividends, which can then be taxed at a lower rate.
- Easy ownership transfers: Many business structures will be terminated if a certain amount of shares are transferred. Shareholders, however, can easily transfer ownership without putting the company in jeopardy because there are no such rules or restrictions.
- Long term growth opportunities: Unlike certain entities, S corps are not dependent on an owner’s life span or exit from a business. They are considered separate from their shareholders, which makes it easier to plan for long term goals or growth opportunities without worrying whether an owner’s decisions or lifespan could disrupt them.
- Various tax savings: There are many benefits regarding S corporation taxes, such as saving on both self-employment and health insurance taxes, deferring payments on taxes linked to retirement accounts, and circumventing the tax law ban on out-of-pocket expenses by creating an Accountable Plan.
Who Should Not Create an S Corporation?
Although the benefits offered by S corps may seem appealing, there are some situations where an S corp may not be the right choice for what the business is trying to accomplish. For instance, if a business wants to reinvest some of its income back into the corporation, it will not be able to do so as an S corp.
Businesses that eventually want to expand to other countries and allow for foreign ownership should also not opt to use an S corp as its filing status since its requirements prevent non-resident aliens from becoming shareholders. If owners ignore this prohibition, the Internal Revenue Service (“IRS”) can revoke the S corp status, charge back-taxes for three years, and impose a waiting period on the business for when it is allowed to obtain its S corp status again.
An S corp may also be the wrong selection for business owners who want to experience unlimited growth potential. Unlike LLCs and C corporations, S corps are limited to a maximum of 100 shareholders.
Finally, the federal tax benefits for S corps are not recognized by every state. Some states completely ignore this status entirely, while other states require additional filings and fees to maintain S corp status at a state level. Thus, those who want to reap the tax benefits that S corps provide may not be able to or may lose funds in the process if they live in one of these two categories of states.
Who Is Eligible to Create an S Corporation?
Although the specific requirements to create an S corp will vary by state, it generally involves taking the following steps:
- First, owners must either form a C corporation or LLC by filing the appropriate documents with the Secretary of State.
- Next, the owners must also file IRS Form 2553 in order to request to be taxed as an S corp.
- Finally, if the state recognizes this tax status, the owners must comply with all other state requirements, including potentially filing additional state mandated forms.
Other criteria that must be met to be eligible for S corp status includes:
- Having less than 100 shareholders;
- Issuing only common stock;
- Ensuring the business is permitted to be taxed as an S corp (e.g., certain financial institutions are prohibited from being taxed as S corps);
- Having shareholders that conform to S corp restrictions (i.e., no foreign shareholders, corporations, or partnerships are permitted); and
- The S corp must be located in the U.S. as well as in a state that permits such a status.
What Is Passive Income?
As briefly mentioned, an S corp may have to pay federal taxes if it accrues passive income. Passive income can only be generated by passive activities. Passive activities are those in which an individual does not materially participate like acquiring rental income.
If within a calendar year an S corp earns income and more than 25% of that income stems from passive income, then it can be taxed at a higher rate. Also, if the S corp continues to earn money in this manner and does not reduce its passive income to less than 25% for three consecutive years, then the IRS can terminate its status and tax it as a standard C corporation.
Do I Need a Lawyer for Help with S-Corporation Issues?
If you are experiencing issues involving an S corporation or are debating whether an S corp is the right fit for your business, you should speak to a local business lawyer as soon as possible.
Experienced tax attorney will be able to explain why an S corp may or may not work for your type of company. A lawyer will also be familiar with the relevant tax laws and can discuss the detailed restrictions you may have to follow if you choose to file as an S corp.
Additionally, if you need assistance with filing and understanding the paperwork for an S corp, your lawyer can help you with these tasks. Finally, if you are caught in a dispute associated with an S corp, your lawyer can help you to resolve the matter as well.