Updated July 3, 2023
What is S Corporation?
The term “S Corporation” refers to the type of firm that meets specific requirements of the Internal Revenue Code (IRS). This type of corporation can pass the income or losses directly to the shareholders without paying any federal tax at the company level.
Typically, small businesses with less than 100 shareholders sign up for S corporation status to avail of the benefits of incorporation while enjoying the tax exemptions associated with partnership business.
Some of the key takeaways of the article are:
- An S Corporation is a legal business entity allowing shareholders to pass through business income or losses directly to their tax returns without paying any federal tax at the company level.
- This type of corporation enjoys the benefits of incorporation while being taxed like a partnership firm.
- The ownership of an S Corporation is restricted to 100 shareholders or less. Besides, the shareholders must be individuals (only US citizens or permanent residents), specific estates & trusts, or certain tax-exempted organizations.
How to Form an S Corporation?
To form an S Corporation, an individual must follow the following steps:
- First, select and reserve a legal name for your firm as per state regulations.
- Prepare your Articles of Incorporation and submit them to the Secretary of State.
- Issue certificates of stock to the existing shareholders.
- Apply for a trade license and other sector-specific certificates to start the business.
- Finally, obtain your Employer Identification Number (EIN) by filing either Form SS-4 or an online application at the IRS website.
- Apply for other approvals required by local and state authorities, which may vary significantly from one jurisdiction to another. Generally, firms need tax ID numbers to pay unemployment, disability, and other payroll taxes.
- File IRS Form 2553 (Election by a Small Business Corporation) within 75 days from your corporation’s formation date.
A corporation must meet the following criteria:
- It must be a domestic corporation with business activities in its home country.
- It shouldn’t have more than 100 shareholders.
- All the shareholders must meet be eligible as per the IRS requirements.
- It has just one category of share stock, which means all the shares bestow equal rights.
- It can’t be a bank, insurance company, or international sales company.
Let us look at the following example to understand the concept.
XYZ Inc. is an S Corporation with two shareholders – John and Jenny, with 45% and 55% ownership, respectively. In the year 2020, the firm earned a profit of $20 million. Therefore, based on the percentage of shares they own, both shareholders will draw incomes aligned with the percentage of ownership.
Given that XYZ Inc. is an S Corporation, the profit will not be reported to the IRS at the company level; instead, it will be noted at the individual shareholder level. John and Jenny will report this profit while filing their income tax returns. Hence, John and Jenny will say $9 million and $11 million for their incomes.
The same logic is applicable in the case of losses. If XYZ Inc. suffers losses of a certain amount, both the shareholders will have to file the losses on their income tax returns in the same proportion of their percentage ownership of the firm.
What Qualifies as an S Corporation?
Typically, the shareholders of an S Corporation must be individuals, specific estates & trusts, or certain tax-exempt organizations. Corporations, partnerships, and non-resident individuals don’t usually qualify as eligible shareholders for an S Corporation.
Some of the significant benefits are as follows:
- The shareholders, employees, officers, and company directors enjoy limited liability protection.
- The shareholders can pass through their share of profit & loss on their tax returns.
- It eliminates the double taxation of income, wherein it is taxable once as corporate profit and again as dividend income.
- The business enjoys perpetual existence beyond the death or cessation of the owners.
- It requires annual tax filing compared to quarterly tax filings of C corporations.
Some of the major disadvantages are as follows:
- Unlike C Corporation and LLC, only US citizens or permanent residents are eligible to be shareholders.
- It has limitations and can’t have more than 100 shareholders.
- It involves a large amount of formation and ongoing expenses for the incorporation of the business, including hiring a registered agent, annual report preparation, franchise tax fees, and other fees.
- Mistakes committed during tax filing can result in the termination of the S Corporation status.
- The IRS closely monitors the income distribution between shareholders and employees, as both categories are taxed differently.
S Corporation is a prevalent type of legal entity for small businesses. It comes with the tax advantages of a partnership firm while offering protection of limited liability like a corporation. Besides, it can be established quickly and maintained much more straightforwardly than a C Corporation.
Although there are several advantages for fast-growing entities, it is subject to a certain size and number of shareholder restrictions, which may inhibit the potential to expand for an S Corporation. However, the good news is that it is relatively easy for an S Corporation to convert to a C Corporation if the business conditions appear favorable.
This is a guide to S Corporation. Here we also discuss the definition, steps to form S Corporation, its requirements, and examples, along with benefits and disadvantages. You may also have a look at the following articles to learn more –