An S corporation is a type of U.S. business entity that offers certain tax advantages to its shareholders. S corporations are not subject to federal corporate income tax, meaning that any profits or losses the company earns are “passed through” to the shareholders and reported on their individual tax returns. This can save shareholders money on taxes, as they only pay tax on their share of the company’s profits (if any).
Learn more about what an S corporation is and how this business structure works for your tax benefits and many others.
What is an S corporation?
Who should establish S corporations?
Businesses that are small to medium in size and have a limited number of shareholders often choose to become S corporations. This business structure provides them with the benefits of a corporation while avoiding some of the drawbacks, such as double taxation (a notable characteristic of a C corp).
Historical background behind S corporation creation
In the past, there were two choices for entrepreneurs in the United States to kick off their businesses. They could consider forming a regular C corporation, which is subject to two layers of federal taxation at the corporate and individual levels. Another way, choose to form a partnership or sole proprietorship to benefit from a single layer of taxation at the individual level, but they would have to give up the guarantee of liability protection.
“Subchapter S” corporation of the tax code was first introduced by The United States Congress in the Internal Revenue Code in 1958. The modernizing of rules governing S corp witnessed significant changes, and a number of restrictions on S corporation eligibility were eased as a result of significant reforms in 1982 and 1996. An S corporation was created to alleviate the concerns of small business corporations about how to balance enhanced liability protection with corporation tax advantages.
The combination of both – a single federal tax layer together with liability protection – has made S corp widely used until today. In exchange for better benefits that fit US family-owned businesses, limitations such as being a domestic enterprise, and stricter shareholder requirements were applied.
What does S corporation mean?
So, what is an S corporation? For the United States federal income tax purposes, S corp is a closely held corporation that meets certain requirements under Subchapter S of the Internal Revenue Code. Specifically, to qualify for “S corp status”, you’ll need to satisfy below criteria:
- Must be a domestic corporation
- Must have only allowable shareholders, which include individuals, certain trusts, and estates
- Must not include other corporations, partnerships, and non‐resident aliens as shareholders
- Have no more than 100 shareholders
- Must have only one class of stock
- Cannot be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations
S corp vs C corp
S corp tax benefit is the most striking difference between S corp and C corp. S corporation’s income is taxed only at the shareholder level, not at the corporate level. This can provide significant tax advantages for shareholders, as they may be able to avoid double taxation on their income.
On the other hand, a C corporation is the most common type of corporation and is taxed as a separate entity at the corporate level. This means that shareholders may be subject to double taxation on their income, as they will be taxed on dividends received from the corporation. However, C corporations can also offer tax advantages, such as the ability to deduct business expenses from their income.
Contrary to C corporations, S corporations help avoid double taxation on corporate income
By the way, we have create a tool suggesting you the most suited structure for you business along with report to help you gaining deeper insight about the entity. Our US Business Entity Selection Tool is at your service
Key features of S corp (Pros and cons of S corp structure)
S corp is a pass-through entity, like LLC, which means that the company’s income is taxed at the individual level. S corps also have the ability to offer financing options and benefits, which can attract and retain key employees.
Ownership and management
There are strict shareholder requirements for an S corporation to be established and operated. Below are certain key characteristics that you should take into account:
- The shareholders of an S corporation are its owners
- Number of shareholders limited to 100 shareholders
- Allowable shareholders of S corp can be:
- Natural persons
- Certain trusts
- Single-member LLCs that have not elected to be taxed as corporations
- In addition, S corporations may have certain restrictions on ownership that other types of corporations do not have.
- Shareholders cannot be an “ineligible corporation” as defined in U.S. Code § 1361. Partnerships and corporations are ineligible.
- S corporation is restricted to have one class of stock
- Only U.S. citizens, permanent residents, certain domestic trusts, estates and tax-exempt organizations can hold stock.
S corporation offers limited liability protection to its shareholders.
Limited liability protection means that the shareholders are not personally liable for the debts and liabilities incurred by the S corp. This is different from a sole proprietorship and general partner, where the shareholders are personally liable for the debts and liabilities of the corporation.
The corporate formalities of an S corp are the same as those of any other corporation. This includes holding regular board meetings, keeping minutes, and issuing stock to shareholders. However, there are some different requirements for S corps. For example, S corps must file a special tax return (Form 1120S) and may be subject to different tax rules than other corporations.
How to set up S corporation
The best way to set up an S corporation is to find a legal firm or trusted service provider that specializes in small business entities and ask them to assist you in the process. This will free you from waste of time and money during the procedure.
You must ensure your business meets S corp eligibility requirements of the IRS, such as being a domestic corporation with only allowable shareholders.
The first step is to file Articles of Incorporation with your state’s Secretary of State office, which will usually require a filing fee. Once your Articles of Incorporation have been filed, you may need to adopt bylaws for your corporation (this is optional but recommended).
The next step is to make the election of S corporation status. Filing Form 2553 with the IRS is required to establish your business as an S corporation. The form must be signed by all shareholders and should be filed with the IRS no more than 75 days after the beginning of the tax year.
Note that you’ll need to have Employer Identification Number (EIN) information to complete the Form. Therefore, don’t forget to apply for EIN from the IRS if you haven’t had it yet. Once you have your EIN, you can also open a corporate bank account.
Under section 1362(a), corporations or other legal entities can elect to be treated as S corporations by using Form 2553
Filing requirements and compliance for S corp
U.S. Income Tax Return
If your business is an S corporation, you’ll need to file Form 1120S, the U.S. Income Tax Return for an S Corporation. This form must be filed annually, and it’s due by the 15th day of the 3rd month after the end of your tax year. For example, if your tax year ended December 31, your Form 1120S would be due March 15 of the following year.
In addition to filing Form 1120S, you’ll also need to file a Schedule K-1 for each shareholder. This schedule details the shareholder’s share of the corporation’s income, losses, and other items. The shareholders will then use this information to complete their individual income tax returns.
State Tax Returns
In addition to the federal tax return, most S corporations will also need to file a state tax return. The requirements vary by state, so you’ll need to check with your state’s tax agency to find out what’s required.
Filing an S corporation tax return can be complex, so it’s a good idea to work with professional service providers and tax preparers who are familiar with the process. This will ensure that everything is filed correctly and on time. Check out BBCIncorp x Taxhub for more information.
The IRS requires S corporations to withhold these taxes from their employee’s wages and pay them over to the government. The shareholders of the S corporation are not considered employees, so they are not subject to these taxes.
However, the IRS does require S corporation shareholder-employees to pay Social Security and Medicare taxes on their share of the corporation’s income.
If your S corporation does business in certain industries, you may be required to pay excise tax. An excise tax is a type of federal tax that’s imposed on certain products and activities, such as gasoline, alcohol, and tobacco.
The requirements for paying excise tax vary by industry, so you’ll need to check with the IRS or your accountant to see if your business is subject to this tax.
Is S Corp right for your business?
The S corporation is a popular business structure for small businesses because it offers tax advantages and flexibility in ownership. If you’re thinking of starting an S corporation, it’s important to understand the requirements and also some downsides, such as increased paperwork and compliance requirements.
Need more discussion on whether S corp is a good option for your business? Leave us some message now.
Disclaimer: While BBCIncorp strives to make the information on this website as timely and accurate as possible, the information itself is for reference purposes only. You should not substitute the information provided in this article for competent legal advice. Feel free to contact BBCIncorp’s customer services for advice on your specific cases.
- What is an S corporation?
- Key features of S corp (Pros and cons of S corp structure)
- How to set up S corporation
- Filing requirements and compliance for S corp
- Is S Corp right for your business?
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