What Is an S Corporation and Why Would Anyone Want One?

What Is an S Corporation?

S Corporations are limited liability entities that pass through tax obligations to shareholders. Each shareholder reports their portion of the business's income and losses to the IRS, along with any relevant deductions. They are each responsible for paying related taxes based on their individual income tax rate.

An S Corporation is initially formed on the state level the same way a standard profit corporation is formed. Once the corporation is filed and an EIN (employer identification number) has been obtained, the corporation applies for an S-Corporation election through the IRS. Confirmation that the S-Corporation status has been accepted is generally mailed to the applicant within a couple weeks. Although there are a few exceptions, the S-Corporation Election should generally be filed within 90 days of the formation of the corporation.

What Businesses Are Eligible for S Corporation?

Only certain types of businesses can qualify as an S Corporation. Per the IRS, To qualify for S corporation status, the corporation must meet the following requirements:

• Be a domestic corporation
• Have only allowable shareholders
  • May be individuals, certain trusts, and estates and
  • May not be partnerships, corporations or non-resident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

If the IRS discovers that a business's tax status is compromised by violating some of the above rules, they have the option to revoke S Corporation status. In that event, they also charge 3 years worth of back taxes on revenues at the corporate level, and the business will be ineligible for S Corporation status for at least five years.

Advantages

Business owners looking for the "best of both worlds" can do so by registering as an S Corporation. Not only do they have the all-important limited liability provision needed to attract investors and generally conduct operations on a public scale, they can also avoid paying taxes on both corporate income and personal dividends.

Unlike small-scale operations like partnerships, S Corporations can have an unlimited amount of managers.

Shareholders of S corporations can register as employees in order to draw a "reasonable" salary, according to company size and industry standards. Shareholder employees only have to pay self-employment taxes and other FICA obligations on these earnings. They can also receive separate distributions for profits, which are taxed as additional income (minus losses) at their personal tax rate.

Disadvantages

Since shares in an S Corporation are limited, they are considered more akin to ownership stakes in a partnership than corporate stock from a publicly traded company.

Owners possessing more than 2% of the overall company value in shares will no longer be able to receive tax-free benefits as a part of their employment. This has less to do with the S Corp election and more to do with the bylaws.

Businesses with concrete assets expected to increase in value (appreciating investments) will face capital gains taxes when the assets are sold, unlike LLCs.

Finally, the limitations on ownership — such as no foreign shareholders — make many possible ventures ineligible. The IRS is quite strict on enforcing the limitations and requirements for S Corporations. The IRS carefully scrutinizes which income is declared as salary compared to distributions. If they find that an income type is being inaccurately reported, they could levy back taxes in addition to other penalties.

What Types of Businesses Work Best as an S Corporation?

S Corporations work best for small-to-medium-sized businesses (SMBs) that wish to have an enterprise-style corporate structure with the reduced tax burden of pass-through taxation.

Many small, service-oriented companies that would generally file as C Corporations should instead register as an S Corporation. Since the IRS began designating certain low-income-earning C Corporations as Personal Service Corporations (PSCs) and subjecting them to a 35% corporate income tax rate, a pass-through tax arrangement is their best alternative. A consultancy provides a typical example of a service-oriented company that often registers as an S Corporation.

Other traits many S Corporations share include:

• A small ownership pool
• Modest annual earnings
• No significant start-up costs
• No major capital investments needed
• High profit generator with minimal risk or overhead

S Corporations Can Be a Profitable Arrangement and a Great Middle Step in Growth

Any company wanting to shield themselves from both liability and double taxation can benefit by learning more about what an S Corporation can offer them. If you are looking to grow your business beyond an LLC or create an enterprise-style company with additional tax benefits, an S Corporation may be the perfect incorporation strategy for you.

You can gain potential benefits by registering your S Corporation in a particular location, such as Wyoming, when you appoint a registered agent with an address in that state.

Review your earnings and goals with both your financial advisors and your fellow stakeholders to determine if registering as an S Corporation would be right for you. If it is, you can enjoy substantial tax benefits and financial flexibility; which help you earn more and keep more of your earnings overall.

If you are interested in form an S Corporation (or any kind of corporation or Limited Liability Company) we can help you! Call, chat or email us to discuss how best to setup your new entity!