What is the purpose and nature of an S corporation?
If you intend to set up an S corp, you should know precisely what the entity is, and what it entails.
An S corporation is a kind of business entity established under state corporation laws, possessing a distinct legal identity from its shareholder(s).
Prior to 1958, every corporation, regardless of their size, were responsible for filing their own federal income tax returns and paying taxes on their earnings. This process, regulated by the Internal Revenue Code‘s Subchapter C, led to these corporations being known as “C corporations.”
A C corporation’s income undergoes “double taxation,” meaning the corporation must pay income taxes. The dividends distributed to shareholders are also taxed in the form of personal income.
Recognizing the challenges this posed for small businesses, Congress introduced a remedy in 1958. They changed the Internal Revenue Code by introducing Subchapter S, which granted relief from double taxation to small businesses. This amendment led to the creation of the “S corporation” designation, and the ability for corporations to be set up as S corps.
Consequently, an S corporation is known as a corporation that opts for taxation under the Internal Revenue Code’s Subchapter S. It is crucial to emphasize that the primary distinction between a C corporation and an S corporation lies in their tax treatment under the IRC, as there exists no differentiation in the state statutes concerning corporations. Please contact our business attorney for help starting an S Corp.
How does the IRS handle taxation for an S corporation?
The IRS treats S corporations as flow-through structures. This means that unlike C corporations, S corporations do not pay federal income tax on their business earnings.
Instead, the business’ income, losses, deductions, and other tax-related items flow through to the owners of the business (such as the shareholders). The S corp submits an information return to the IRS, outlining each owner’s portion. Business owners are then responsible for paying taxes on their respective shares of the S corporation’s income. This is true even if the funds remain within the business rather than being distributed.
By setting up an S corp, small businesses can avoid the “double-taxation” scenario where both the shareholders and corporation are taxed on the income that is distributed to the shareholders.
Which corporations are eligible for to set up an S corp?
Not all corporations can set up an S corp and thus attain the coveted tax status of an S corp. Subchapter S imposes several limitations on companies, including the following:
- Shareholders must be individuals, specific types of estates, trusts, or specific kinds of tax-exempt entities. For instance, a partnership cannot set up an S corp.
- The corporation has to be an American corporation with a maximum of one hundred shareholders. (Related groups may be counted as one shareholder.)
- If set up as an S corp, a corporation can only issue a single class of stock, although variations in voting rights among common stock shares are allowed. It is also prohibited from having a shareholder who is a nonresident alien.
Furthermore, certain kinds of businesses (such as insurance companies and financial institutions) are ineligible to set up an S corp, even if they meet other Internal Revenue Service requirements.
An S corporation must maintain compliance with the above requirements. If the corporation does not do so, for example by selling shares to over one hundred individuals or to a corporation, a foreign citizen, a partnership, or by creating multiple classes of stock, it can no longer be set up as an S corporation.
Benefits of setting up S corporations instead of LLCs
A limited liability company also has the capability to skip double taxation. Unless the LLC’s owners (referred to as members) decide otherwise, a single-member LLC is treated as disregarded for tax purposes, and its income is regarded as the member’s personal income. In the case of a multi-member limited liability company, it is taxed similarly to a partnership, with the earnings flowing through to the individual members.
While both structures offer flow-through taxation, there are distinct advantages to setting up an S corporation instead of an LLC, including:
- Dividends of an S corp are exempt from self-employment tax, a benefit not extended to LLCs. This stems from how employment taxes, such as Social Security and Medicare, are handled in an S corporation. In this structure, a shareholder who is also an employee of the corporation is viewed as both an employee and an owner. By paying themselves a reasonable salary and taking the remaining profits as dividends, only the salary portion triggers employment taxes, and not the dividend.
- In LLCs operating as disregarded entities or being taxed in the manner of partnerships, a member who is actively involved in the company is considered solely an owner, and the entirety of the profit distribution is subject to taxes on self-employment. (It is important to note that the Internal Revenue Service scrutinizes this practice to prevent the manipulation of dividends and compensation. They may contest salaries they deem unreasonable and attempt to reclassify dividends as salary.)
- S corporations have a smoother transition path to becoming C corporations compared to LLCs. Some startup owners may envision securing funding from private equity funds or other external investors down the line. These investors typically prefer to invest in C corporations. Similarly, if there are plans for an IPO (an S corp cannot pursue this due to restrictions on shareholders), an S corporation may not be the suitable choice.
If the owners initially seek flow-through taxation, they might lean towards setting up an S corporation instead of an LLC. This is because an S corporation is essentially the same entity as a C corporation and only requires a filing with the Internal Revenue Service to alter its tax status. Conversely, a limited liability company is distinct from a corporation and would need to undergo a conversion process in accordance with state corporation and LLC laws.
Drawbacks of setting up S corporations compared to LLCs
If someone wants to set up an S corp, they should be aware of the potential cons, including the below:
- LLC offers greater flexibility as an entity. Plenty of small business owners favor a limited liability company over a corporation due to its increased flexibility in management and the ability to allocate management and financial rights. For instance, if you set up an S corp, profits must be given out in proportion to capital contributions, whereas LLCs do not face the same restrictions.
- LLCs can achieve flow-through taxation without the constraints of Subchapter S. A limited liability company can attain flow-through taxation without being bound by the limitations imposed on an S corporation, such as limitations on the type and number of shareholders, as well as the classes of ownership interests.
If I intend to set up an S corporation, what steps should I take?
It is crucial to understand that an “S corporation” is not a standalone kind of business entity. Rather, it is a specific tax designation for a corporation. Hence, the initial step for anyone seeking to set up an S corp is to establish a corporation.
The process of setting up an S corp typically involves selecting a state of incorporation, choosing an appropriate corporate name, designating a registered agent, and drafting and submitting the articles of incorporation to the Secretary of State or the relevant state filing office.
It is worth noting that state corporation laws treat C corporations and S corporations the same. Consequently, the S corporation must adhere to all the requirements outlined in its home state’s corporation law. This may encompass tasks like submitting an annual report, letting the state know of any changes in registered agent or office, fulfilling franchise tax obligations, keeping corporate records, conducting meetings, and more.
Since every corporation is initially taxed as a C corporation by default, after establishing the corporation, it is imperative to make the appropriate Internal Revenue Service election to set up an S corp. This is accomplished by submitting Form 2553 to the IRS.
There is no time for a cautious approach: set up an S corp at the start of your tax year
In order for an eligible corporation to set up an S corp for tax benefits, the election must be correctly filed using the appropriate forms within a specific timeframe. If this election is not submitted by the deadline for the current tax year, it will only take effect in the following year for the corporation.
The deadline for tax year elections falls within the initial phase of that tax year, within a specified timeframe. It must be made during the corporation’s tax year and no later than the fifteenth day of the 3rd month of that tax year.
It is important to note that for new corporations, the tax year typically does not commence on January 1st. Therefore, it is advisable to set up the S corp promptly to avoid any concerns about meeting the deadline for the first tax year.
When you set up an S corp, it remains in effect for all subsequent years until it is terminated, either voluntarily by you or by the Internal Revenue Service for non-compliance with S corp regulations. It is not necessary to re-elect each year.
Unanimous consent from all shareholders is required for the election to be considered valid. Without this unanimous agreement, it is not possible to set up an S corp.
In Summary
An S corporation is a type of corporation that distributes its income, losses, and expenses among its shareholders based on their ownership stake in the company. Setting up an S corporation taxation can lead to significant federal income tax savings. (It is worth noting that many states, though not all, also treat S corporations as pass-through entities for purposes related to state income tax.)
Furthermore, for corporations where owners are actively involved in the operations, an S corporation structure can result in savings on the owner’s self-employment tax.
Of course, the choice of business structure for a small business owner hinges on various factors. If you find the advantages of an S corporation appealing, it is advisable to discuss setting up an S corp with your advisor.
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