
Designating your corporation for tax purposes as an S corporation, or S corp, makes the business its own legal entity, reducing liability for you and other stakeholders. While this type of business entity isn't right for everyone, it is beneficial for small domestic companies that don't intend to borrow money. Here's everything you need to know about S corporations.
What is an S corp?
An S corporation is a small business that elects to be taxed under subchapter S of the Internal Revenue Code. This tax designation enables corporations to pass their corporate income, credits, and deductions through to their shareholders — also known as a pass-through structure. The shareholders divide the profits or losses among themselves, and the income is reported on their individual tax forms.
This structure helps corporations avoid double taxation, which is when a business is taxed at both the corporate and individual levels. The IRS requires S corps to pay going-rate salaries to the owners in order to avoid having to pay income or self-employment taxes.
Because an S corp is a tax designation, owners cannot register their organization as an S corp. Instead, a legal business entity, like an LLC or a corporation, must be registered and then filed under an S corp status.
[Read more: How to Start an LLC]
Filing requirements of an S corp
According to the IRS, there are certain requirements to becoming and remaining an S corp. The business must meet the following criteria:
- It must be a domestic corporation.
- It should only have allowable shareholders that include individuals, certain trusts and estates that are not partnerships, corporations, or nonresident alien shareholders.
- There should not be more than 100 shareholders.
- It should only have one class of stock.
- It should not be an ineligible corporation, such as an insurance company or domestic international sales corporation.
If your business grows beyond the scope of a small business, it may be difficult to remain within these parameters.
You'll want to consider your business’s current and future needs before filing as an S corp.
Pros and cons of filing as an S corp
Some advantages to filing as an S corp include the following:
- S corporation status helps save on taxes. Businesses designated as S corps do not have to pay federal taxes at the entity level; S corporation revenue is only taxed at the shareholder level. Additionally, S corp owners don't need to pay self-employment taxes on distributions and only owe on income they classify as salary.
- S corporations offer corporate dividends. Shareholders in an S corporation can be listed as company employees, earn salaries, and receive tax-free corporate dividends if the distribution does not exceed the shareholder's stock basis.
- S corps offer limited liability protection. Owners of an S corp are not held personally liable; rather, the business as its own entity takes on liability.
- S corps help organizations establish credibility. Potential vendors, lenders, and customers may see an S corp filing status as a more tangible commitment to the business than sole proprietorships or partnerships.
However, there are also disadvantages to keep in mind, including these:
- S corps come under heavier scrutiny from the IRS. S corp status must be approved by, and can be revoked by, the IRS. S corporations must allocate profits and losses based strictly on ownership percentage and share number and pay reasonable salaries to shareholders-employees before any corporate distributions to remain in compliance.
- Filing as an S corp entails fees. In addition to initial filing fees, some states require S corp owners to pay annual report fees, franchise taxes, and more.
- Filing as an S corp puts limits on growth. Only businesses with 100 or fewer shareholders can file as an S corp.
[Read more: How to Register Your New Business]
Tax implications for S corporations
As pass-through entities, S-corps pass deductions, losses, income, credits, and profits, directly to shareholders. These shareholders then report their share of the business's profits on their personal taxes rather than at the corporate level.
As a result, S corporations have their own unique filing process, involving IRS Form 1120-S, U.S. Income Tax Return for an S Corporation, and Schedule K-1 (Form 1065):
- IRS Form 1120-S reports income, losses, credits, deductions, employee wages, officer compensation, and other income and expense details.
- Schedule K-1 forms are supplied to individual shareholders and partners, to be completed separately, detailing their own portion of all income and expenses.
In addition to these forms, the business owner must be paid a W-2 salary and report that salary as income on an IRS Form 1040 alongside distributions and losses via a Schedule E form. All forms are due by the April 15 tax filing deadline.
Is an S corp right for your business?
S corp filing status may be right for businesses that meet the following criteria:
- The entity will provide a service.
- It will not have significant startup costs, including major equipment purchases.
- Management intends to stay small (i.e., under 100 employees).
- Only one type of stock has been issued.
- The business plans to rely only on U.S. shareholders.
You'll want to consider your business's current and future needs before filing as an S corp. However, it is possible to convert from an S corp status if a different filing structure is a better fit down the line.
[Read more: The Most Common Business Entities for Startups]
Common pitfalls to avoid when running an S corporation
Like any other business process, running an S corporation can be difficult to navigate. Here are a few common pitfalls to avoid along the way:
- Not paying yourself a "reasonable" salary: Many professionals recommend the 60/40 rule — designating 60% of business income as salary and 40% of shareholder distributions — as an unofficial rule. You can also look to industry standards and statistics to estimate what you should pay yourself.
- Missing self-employment tax deductions: If you, as the business owner, pay health insurance premiums for your family, you can claim it as a deduction on your personal tax return. You may also be eligible for the home office deduction if you operate out of the home (in an area exclusively used for work).
- Violating the rules for S-corp eligibility: As your S corp grows and evolves, make sure it maintains eligibility requirements with respect to shareholders, stock classes, and filing deadlines. When in doubt, consult a professional — such as an accountant or lawyer who is familiar with S corporation filing — who can help you understand your legal requirements and stay in compliance.
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