Selecting a business structure is a crucial consideration for any American entrepreneur. As a business owner, you will face taxation, legal liability, capital acquisition, and profit distribution issues that depend on the legal structure you implement.
Incorporation as a S Corporation or S Corp is fairly common in small and mid-market businesses because of the optimal stratification of taxation and legal shield combined with operational laxity it provides.
In this step-by-step guide, we set forth the process of establishing an S Corporation, its definition, advantages and limitations for comprehensive understanding.
What is an S Corporation or S Corp?
An S Corporation, or Subchapter S Corporation, is an IRS tax differentiation allocated to a given corporation or limited liability company (LLC) that meets certain requirements.
While it is used often as synonym for type of business entity, it is worthy to add that “S Corporation” is a business tax classification rather than a legally recognized entity.
How it Operates:
When a corporation or LLC chooses to be taxed as an S Corp, it is classified as a pass-through entity for federal tax purposes. This indicates that the business is exempt from paying corporate income taxes.
However, income, losses, deductions, and credits “pass through” to shareholders which means they are claimed on their respective individual tax returns.
How the S Corp Started:
The S Corporation came into existence with the 1958 Small Business Act. The aim was to provide a business formation that would enable ownership of a corporation while having its income and losses “passed through” to the owners to avert taxation’s redundancy.
Overview of S Corp Attributes:
- Not subject to taxes on a corporate level
- Shareholders submit income in personal tax filings
- Must adhere to the IRS qualifying guidelines
- Can be a corporation or an LLC that opts for S Corp election
S Corporation Advantages
Constructing an S Corporation enables a plethora of advantages especially to small-scale business proprietors aiming for optimal tax deductions while safeguarding personal liabilities.
1. Pass-Through Taxation
An S Corporation does not incur an entity level tax like a C Corporation does (which results in double taxation- one at the corporate level and the second when profits are distributed to shareholders). An S Corp permits the income (or losses) to pass through to the shareholder’s personal tax return. That extra layer of taxation is avoided which, in most scenarios, is beneficial.
2. Self-Employment Tax Savings
A major benefit that most people find appealing is the ability to divide payment into salary and distributions. Each shareholder working for the corporation must receive a “reasonable salary”, part of which is payroll taxed. The remaining profits can, however, be taken in the form of dividends which are not payable in self-employment tax, making tax savings possible.
3. Limited Liability Protection
An S Corp limits the legal liability of its shareholders because they are not personally liable for the corporation’s debts or legal responsibilities. Stated differently, creditors do not have the right to claim the private possessions of the shareholders such as their homes, cars, savings, etc., in order to settle the debts of the business.
4. Improved Credibility and Brand Image
With the inclusion of “Inc.” or “Corporation” in your business name, there is an improvement in credibility concerning banks, business investors, suppliers, and even potential customers. It gives the perception of an organization that is well established and offers greater industry structure.
5. Convenience of Business Ownership Transfer
The sale or transfer of S Corp shares can easily be done without any taxation or dissolving the entity. This greatly facilitates the selling of the business in the future or the addition of new owners.
Disadvantages of an S Corporation
An S Corporation provides many advantages, but is not suitable for all types of businesses. The following points are some notable restrictions and possible disadvantages that should be noted.
1. An Eligibility Requirement that is Too Restrictive
The S Corp status comes with a number of eligibility criteria that must be satisfied.
- There should be no more than 100 shareholders
- All shareholders of the corporation should be citizens or permanent residents of the United States.
- The corporation may only issue one class of stock.
- Must be a domestic corporation or LLC.
Failure to satisfy any of these conditions will result in loosing S Corp status.
2. Closer Surveillance of S IRS Corporation
Since S Corps provide the ability to save taxes through distributions, the IRS tends to scrutinize how much of salary is paid to the shareholder-employee. Excessively low salaries which give distributions leave the company vulnerable to penalties for underpayment of employment taxes.
3. Heightened Administrative Responsibilities
S Corporations have more formal requirements than Limited Liability Companies (LLCs) or sole proprietorships. These include:
- The keeping of corporate bylaws
- The conducting of annual meetings
- The documenting of minutes for meetings
- The submission of detailed annual reports
All of these requirements can pose challenges, especially for solo entrepreneurs.
4. Restriction on Raising Capital
S Corporations are unable to have foreign or institutional investors and can only issue one class of stock. Unlike S Corporations, C Corporations are able to issue multiple classes of stocks and seek venture capital or private equity funding.
How to Set-Up an S Corporation
An S corporation needs a multi-step approach, which includes creating a business entity with the state, alongside opting to have S Corp tax treatment with the IRS.
Step 1: Picking Your Business Name
Your business name should be original and not conflict with any other names that have already been registered in your state. You must also follow state naming conventions, which usually include a “Corp” or “Inc.”
Tip: Remember to use the Secretary of State’s website for the name search. For marketing purposes, you may also want to check if the domain name is available.
Step 2: Appoint A Registered Agent
A registered agent can be an individual or a business entity that is legally recognized to accept legal papers and other governmental correspondence on behalf of your business. The agent must have a physical address in the state where you’ll be forming the corporation.
Of course, you have this option as well, but it is generally advisable to hire a professional registered agent service, as it provides privacy and is more convenient.
Step 3: Submit Articles of Incorporation
Articles of Incorporation (also known as a Certificate of Incorporation), which is a legal document need to be created and filed with an appropriate state agency responsible for business registration in order to set up a corporation. This document typically includes:
- Business name and address
- Purpose of the business
- Registered agent information
- Names and addresses of incorporators
- Number and type of authorized shares
Filling fees typically differ from one state to another and range between $50 and $500.
Step 4: Write Corporate Bylaws
These corporate bylaws are rules within the company for governing certain matters such as the internal organization of the corporation. Corporate bylaws are not required to be filed with the state, but a company will typically need them for compliance and practical reasons.
Bylaws should cover:
- Shareholder rights
- How to elect directors
- Voting procedures
- Meeting schedules
- Officer responsibilities
Step 5: Obtain an EIN (Employer Identification Number)
An EIN or Federal Tax ID is obtained through the IRS and is obligatory for:
- Opening a business bank account
- Employing individuals
- Tax filing
You may apply for an EIN at no charge through the IRS website.
Step 6: Submit IRS Form 2553 if you wish to choose S Corp status
If you wish to elect S Corporation tax treatment, you need to submit Form 2553: Election by a Small Business Corporation to the IRS. The form requires signatures from all shareholders.
Deadline: You are required to submit it within 75 days of incorporation, or by March 15 for that tax year to grant S Corp status for that year.
Missing the deadline means your company will automatically be taxed as a C Corporation (or LLC) until the next tax year comes around.
Step 7: Make Sure Ongoing Requirements Are Met
Once your S Corp is operational, make sure to satisfy all pertinent federal and state requirements, including but not limited to:
- Filing all annual reports and franchise taxes (where applicable)
- Conducting annual meetings for shareholders and directors
- Keeping records of decisions made along with meeting minutes and books
- Paying estimated quarterly tax obligations
Failure to comply with required corporate governance procedures could result in administrative dissolution or forfeiture of S Corp privileges.
Who Can Form an S Corp?
Not all businesses qualify for S Corporation status. Here’s a breakdown of the IRS requirements:
| Requirement | Details |
| Entity Type | Must be a domestic corporation or LLC |
| Shareholder Limit | No more than 100 shareholders |
| Residency | Shareholders must be U.S. citizens or permanent residents |
| Stock Class | Only one class of stock allowed |
| Eligible Shareholders | Individuals, certain trusts, and estates (not partnerships or corporations) |
| Business Type Restrictions | Some financial institutions, insurance companies, and domestic international sales corporations (DISCs) are not eligible |
Key Considerations When Choosing an S Corporation
S Corporations provide an appealing option for small business owners seeking a balance between tax efficiency and liability shielding, but they do have some limitations.
Best suited for:
- Individual contractors or small business owners with a reasonable income.
- Professionals like freelancers, consultants, or agencies.
- Businesses that do not plan to seek venture capital.
- Domestic businesses with individual shareholders.
Least suited for:
- Businesses controlled by foreign shareholders.
- Startups targeting institutional investors.
- Businesses that require different types of shares.
- Businesses that desire minimal operational limitations while organized in multiple states.
Make sure to seek professional advice from an accountant or business lawyer before proceeding with any decisions.
Conclusion
Establishing an S Corporation is one of the best options available for small business owners looking to reduce tax liabilities, lessen tax burdens on personal assets, and create an enduring firm.
Provided that S Corporations are aligned to a business’s unique structures and ongoing compliance requirements, the business will be able to access the benefits of pass-through taxation and corporate protection.
Need to Set Up an S Corporation?
Bizstartz simplifies the process of setting up U.S. businesses for clients across the globe. We take care of everything including incorporating your S Corp and maintaining compliance.
✅ Business Formation
✅ Submission of Application for Employer Identification Number (EIN)
✅ Filing of Form 2553 at the Internal Revenue Services (IRS)
✅ Services of a Registered Agent
✅ Support with Compliance for the Year
👉 Get in touch with us to set up your S Corp today with minimal hassle!
Frequently Asked Questions (FAQs)
1. Can single-member LLCs choose S Corp status?
That’s right, provided the single-member LLC meets the IRS enrollment prerequisites, it can be categorized as an S Corporation with the submission of Form 2553. This is a popular option for LLC sole proprietors due to the reduced self-employment taxes offered while still having limited liability protection.
2. How to determine ‘reasonable salary’ for owners of S Corp?
It is required by IRS that S Corp shareholders who actively work in the company must pay themselves an appropriate salary before distributions are given out. A reasonable salary follows the industry standard for the position so it poses no risk of IRS audit or other penalties which could arise from not adhering to typical earning thresholds in an individual’s field or position.
3. Is it possible for another business entity to own an S Corporation?
No. S Corps are not permitted to be owned by other corporations, LLCs, partnerships, and even non-resident aliens. Shareholders must be U.S citizens or permanent residents and these individuals, not entities. Certain types of trusts and estates might also be considered shareholders.
4. In what ways can S Corp owners pay themselves?
Payment can be done through:
- As an S Corp owner-employee, you pay yourself through:
- A salary (which is paid through payroll along with tax withholdings)
- Dividends or distributions (profit shares that are not subject to self-employment tax)
IRS regulations require that both methods of payment be used in the correct ratio in order to remain compliant with IRS regulations and avoid tax penalties.
5. What is the effect of my business no longer qualifying for S Corp status?
Your business is at risk of losing S Corporation status if you violate any of the following rules: have over 100 shareholders, have more than one class of stock, or allow foreign ownership. S Corp status can also be revoked if the IRS finds any of these violations.
Your business would then be taxed as a C Corporation and at risk of paying additional tax fines or penalties. Maintaining compliance is strongly advised, so consider monitoring compliance changes continuously.
