There are numerous categories a business can register as in the United States. You may be familiar with an LLC, but what is an S Corporation?
An S corporation, or S corp for short, is when a company meets very specific requirements set forth by the Internal Revenue Service, or IRS. An S corporation is typically for a small business, with less than 100 shareholders, and provides tax benefits to the business owner(s).
How Does an S Corp Work?
S Corporation rules are in subchapter S of the Internal Revenue Code (sections 1361-1379). Income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of distributions, similar to partnerships.
Unlike partnerships, shareholders can become employees of the business and draw income as an employee salary in addition to dividends and other distributions. On a high level, an S corporation functions like any other company.
But behind the scenes, from a federal tax filing perspective, an S corp is different. There are various rules/requirements the company must meet to be S corp eligible, which we’ll cover below.
Qualifications Required to File for S Corp Status
As mentioned, an S corporation must meet specific requirements that the IRS has set forth. Such requirements include:
- The company must have headquarters in the United States.
- They can only have one class of stock. There cannot be common and preferred stock issued, which is common amongst public companies.
- The company can have up to 100 shareholders, but cannot exceed that figure.
- The shareholders must also meet criteria established by the IRS.
- The type of corporation is also subject to approval. Various financial and insurance companies cannot be granted S corporation status.
Who is Considered as Shareholders
An S corporation defines shareholders, under the current tax law, as:
- Certain trusts and estates can be shareholders.
- Certain exempt organizations.
- The shareholder must be a United States citizen.
- The shareholder must NOT be a partnership or corporation.
- All shareholders must consent to the election.
S Corporation Taxes
Instead, the revenue, expenses, and profit gets allocated to each shareholder, who reports this income and profit on their own personal tax return. The tax liability is contingent on what tax bracket a specific shareholder falls into.
The Cash Method
A business can either do their accounting on a cash basis, or accrual basis. S corporations typically do cash basis accounting, which is an easier to use accounting system.
Under the cash method of accounting, expenses are recorded as the income comes in, or leaves, the business. You don’t need to forecast future income, and adjust accordingly as you would have to with accrual accounting.
Example of S Corporation
Many small businesses make the election to be an S Corporation. Infact many LLCs elect to be taxed as an S Corporation, as the LLC election is made on a state level, while the S Corp election is made at the Federal level.
Features/Factors Involved with S Corps
There are numerous features and factors that come along with S Corps.
Similar to limited partnerships, limited liability companies, and C corps, one of the main advantages to the S corp election is some degree of liability protection. This means owners are not subject to responsibility for most business debts.
No Double Taxation
A typical C corporation pays corporate income tax. If the business is often funding payroll, the employees will be taxed on their income as well!
This is double taxation, and can be infuriating as a business owner. An S corporation does not pay corporate income tax, therefore, there is no double taxation.
Each shareholder of the company reports their income on their own personal tax filings. The money the S corporation generates is only subject to tax once.
Because shareholders can only be held liable for the amount of their investment, an S corp election may be an advantageous election for raising capital. Shareholders will not assume risk on personal assets for business debts.
Advantages of S Corps
S corporations have numerous advantages. The most common advantages include:
- The owners have greater asset protection.
- Owners can elect to be employees of the S corp and be receive salaries in addition to dividends and other distributions.
- The taxes are paid by the shareholders, not in addition to the corporate tax rate, which avoids double taxation.
- Shareholders can write-off losses on their personal tax return, which is beneficial for start-ups.
- S corporations can use the cash method of accounting.
Disadvantages of S Corps
Despite the advantages an S corporation has, there are disadvantages worth considering as well. Such disadvantages include:
- Only one type of stock can be issued.
- There can only be 100 shareholders.
- Some states do not recognize S corporations.
- There are specific criteria a shareholder must meet.
LLC vs S Corp
Let’s compare an LLC Vs. S Corp.
An LLC, also known as a limited liability company, is a type of business entity. An LLC provides liability protection for its owner(s). Some of an LLC’s most common differences include:
- An LLC can have more than 100 shareholders.
- LLC shareholders do not need to meet as strict criteria as s corporation shareholders.
- An LLC is a business entity, whereas an S corp is the tax classification of a specific company.
Taxes and Entities Are Complicated
Understanding all the tax and entity nuances of forming a business is complex! There are negative ramifications if set up incorrectly, and it can end up costing the business owner quite a bit of money.
Working with a financial advisor, and a registered tax agent, is a great way to ensure your business is being set up in the most preferential fashion. S corporations are one option to consider, but there are a long list of questions/variables that must have answers before taking action.