Atlantic Monthly recently reported that “the coronavirus decimated an unprecedented number of small businesses, but also enabled the launch of an unprecedented number of new ones. Business formation surged strongly in the second half of 2020. Entrepreneurs launched 500,000 more new businesses … and today Americans are starting companies at the fastest-ever recorded pace.” This is very exciting … and frightening. There are so many things for a new business owner to know. Especially when setting up the business.
Our business entity series explains each of the business structures, helping to identify which is the right fit for a new business. Today we’ll discuss an S Corporation and how it differs from an LLC and C Corporation. This one is a bit different since technically it’s not a business entity type, but a tax classification. By choosing this designation, you are letting the IRS know that your business should be taxed as a pass-through entity, similar to an LLC or a partnership, rather than C Corporation.
For advice on other ways to structure your business, check out our blog.
What is an S Corporation?
S Corporations, also known as S subchapters, are named for Subchapter S of Chapter 1 of the Internal Revenue Code. It is most like an LLC. In fact, many S Corporations start off as LLC’s. There can’t be more than 100 shareholders in an S Corporation. Also, the shareholders have to be US citizens or residents. Many businesses apply for S Corporation status once they become profitable since this entity offers tax advantages that C Corporations and LLCs don’t offer.
Business that are looking for a high level of protection of their personal assets from lawsuits or creditors might choose to apply to the IRS to become an S Corporation. An S Corporation, like an LLC, is a pass-through entity, but the taxation is different since each is taxed under different sections of the Internal Revenue Code. Companies will choose to set up as an S Corporation if they want the advantages of a corporation with pass-through taxation and if they plan on eventually going public. The company’s shareholders split up income and losses and report it on their personal income tax returns.
The Advantages of a S Corporation
- Owners receive limited liability protection, regardless of tax status. This means that there is legal and financial separation between the shareholders and the business. The corporation can sue and be sued, not the shareholders.
- S Corporations are exempt from paying corporate income tax. The S Corp tax rate is based on the owner’s personal income level.
- It is a pass-through entity for Federal and most State income taxes, avoiding double (corporate and personal) taxation. S Corporations pass their corporate income, credits, and deductions to shareholders.
- LLC’s can choose to be taxed as an S Corporations. S Corporations can choose to revoke its S election and revert back to a C Corporation.
- Dividends from an S Corporation to its shareholders are usually tax-free to the extent of each shareholder’s tax basis in the S Corporation..
- Income that passes-through from an S Corporation is not subject to self-employment tax. However, S Corporation must pay shareholder-employees a reasonable compensation for the services provided prior to paying out dividends.
- It is easy for the owner to transfer interests to other owners without significant tax consequences or shutting down the entity.
- This designation often helps attract investors and prove credibility to suppliers and customers since this type of business mandates more oversight.
- S Corporations can incentivize key employees through awards of its stock as additional compensation.
The Corporation does not dissolve when owners leave the business, so the business can exist indefinitely.
The Disadvantages of a S Corporation
- There is less flexibility with this structure. You can only offer one class of stock, which might be less appealing to investors, and the owner has less control.
- The business must meet specific guidelines by the IRS to qualify as an S Corp.
- S Corps are not permitted to have non-US citizens, certain trusts, partnerships, or other corporate entities as shareholders.
- There are more formalities, paperwork, and regulations required by Federal, State, and Local governments, such as the writing of bylaws, issuing stock shares, electing board of directors, and maintaining formal board of directors’ meetings and minutes. An LLC does not require this.
- You might need to hire an attorney to help complete the articles of incorporation since they must be legally correct to be valid.
- The IRS keeps a close eye on how much you pay yourself in salary and dividends. The amount you claim receiving in dividends must be reasonable, so you are not flagged for trying to avoid/lower self-employment taxes.
Some states may not recognize Federal S election and require separate S election at the state level.
The Steps Involved in Setting Up a S Corporation
These steps must be followed. Failure to comply with any of the steps could result in revocation of the S Corp status by the Internal Revenue Service.
- Talk to and hire a capable business attorney.
- Talk to and hire a capable accountant, especially with an S Corporation. The tax forms can be complicated.
- You must first register as an LLC or C Corporation.
- Select and obtain a unique corporation name that ends in “Corporation,” “Incorporated,” “Limited,” or an abbreviation of any of those words.
- Choose a board of directors and corporate officers.
- File all other regulatory filings for the state you plan to do business in, including a Certificate of Incorporation with the Secretary of State’s office. Fees vary by state. File with a registered agent, who will receive all legal documents and correspondence between federal and state agencies
- Once you receive your Certificate of Incorporation, apply for an EIN. Then submit Form 2553 to elect S Corporation status for tax purposes.
- Set up a business bank account.
- Procure the required insurances. Shareholders receive personal liability protection from the corporation, but to protect business assets, the corporation will need insurance coverage.
- Get professional bookkeeping support.
Tax Information for a S Corporation
An S Corporation will file an information return, Form 1120S, at the Federal level. The tax return deadline for S Corporations is March 15 for calendar year filers. A 6-month extension is available by filing Form 7004 by the original due date. The S Corporation will issue Schedule K-1 to each shareholder, and the shareholder will report his/her share of income or loss on individual income tax returns. For New York State, it is required to file a NY General Business Corporation Franchise Tax Return (NYS CT-3-S). Similarly, each shareholder will receive Form New York Schedule K-1 Equivalent that provides state additions and subtractions, and nonresident shareholder’s distributive share of income and deductions for state reporting purposes.
If the business is doing business in New York City, the company must also file the New York City Business Corporation Tax Return (NYC-3L or NYC-4S, for corporations that are not required to file NYC-3L, or NYC-4EZ for the short form.). It is important to note that NYC does not recognize S corporations and the above forms levy the regular corporation tax rate.
If you have any questions about whether this is the right designation for your business, or about the requirements, please contact us. As with all major decisions, it’s best to speak with your accountant prior to deciding which business structure is the best fit.