Posted by Pat Raskob

Understanding S-Corporation Taxation

Understanding S-Corporation Taxation

An S corporation, or sometimes referred to as S subchapter or S Corps, is a type of incorporated legal business entity. An S corporation has a similar business structure to a limited liability corporation and a C corporation, but what makes it different are the distinct characteristics that meet specific IRS requirements.

An S Corp will protect an entrepreneur from certain debts, just like an LLC or C Corp. The business is separate from the owner. If there is a debt collection or lawsuit against the business, the owner's personal property is protected.

A great advantage of an S corporation is that it is a pass-through entity like an LLC. This allows corporate income, losses, deductions, and loans to flow directly to shareholders without paying federal corporate tax.

Like a C corporation, an S corporation can raise funds from outside investors. In essence, an S Corp shares the best benefits of an LLC and a C Corp.

In order for the business to be eligible for S Corp, it must meet the strict requirements set by the IRS. These requirements include:

  • Mandatory annual meetings of shareholders

  • May not be owned by any other business entity, including other S Corps, C Corps, LLC, business partnerships, or individual companies.

  • No more than 100 major shareholders or owners

  • Owners must be permanent residents or US citizens. 

  • Required board of directors 

  • Strict legal regulations

  • Strict rules on issuing stocks.

Creating an S Corps is similar to creating any other business. If you've decided to start your own business and have decided that an S Corporation is best for you, you can follow these steps to get started.

  • Step 1: Name the business - Your business needs a unique name that another S corporation does not use in your jurisdiction. You can reach your local state business offices to find out where you can get a list of current S Corps to see what names are used.

  • Step 2: Establish your Board of Directors: Each S Corps should have a Board of Directors. The board of directors is the governing body of your company which represents the shareholders of the company. One of the requirements for forming an S Corp is that the board of directors hold regular meetings and keep the minutes of those meetings. The board of directors will also develop policies for the management of the company.

  • Step 3: File the Articles of Incorporation: When forming an S Corps, the articles of incorporation must be filed with the IRS and the Secretary of State. You must comply with your state's rules and regulations regarding the filing of articles.

  • Step 4: Issuance of shares: S Corps can be in the form of ordinary or preferred shares.

  • Step 5: File Corporate Bylaws: Bylaws are another area of the S Corps that the IRS strictly regulates. The bylaws will describe the process for the election and dismissal of directors from the board of directors, how shares are sold, the date of meetings, the right to vote, and the treatment of the death of a director.

  • Step 6: Submit Form 2553 to IRS - After the approval of your S Corps by the Secretary of State, you must file the Election by a Small Business Corporation Form with the IRS. This is Form 2553 and makes your business official with the IRS.

  • Step 7: Designate and File a Registered Agent: Depending on your state, you may need to designate a registered agent for your S Corp. The registered agent will oversee the receipt of all legal documents between the company and government agencies.


Benefits of an S Corporation

S Corps offers a number of advantages to entrepreneurs, and these advantages often outweigh the disadvantages.

The most important benefit is the tax benefits that flow from forming an S corporation. S Corps are pass-through entities, so they do not have to pay federal taxes at the corporate level. This allows business losses to offset shareholder income by reducing taxes paid.

Shareholders of S Corp can also be considered employees and can receive a salary as an employee. Other shareholder benefits include the receipt of dividends and other tax-free distributions.

Like an LLC, an S Corp protects the personal property of its shareholders. The shareholder will not be personally liable for the debts of the company.

Another advantage of starting an S corporation over a C corporation is the ability to pass through interest or adjust the basis of ownership without incurring tax consequences or being forced to comply with complicated accounting rules.

Ultimately, creating an S Corp will give your business credibility that you cannot get with a sole proprietorship or LLC. Suppliers, investors, and customers may be more likely to work with an S Corp because it shows a commitment to the company and the shareholders.

While the pros of an S Corp usually outweigh the cons, if you are considering forming an S Corp, you should consider these potentially negative aspects:

  • S Corps are more difficult to create and maintain than an LLC due to the requirements of the board of directors, annual meetings of shareholders, and regulations on issuance of shares.

  • Some states do not allow S Corp income tax on the owner's personal income tax return.

  • The entrepreneur has less control than an LLC or a sole proprietorship.

  • There are many fees associated with an S Corps, such as annual report fees and bylaws.


How are S Corps taxes collected?

S Corps is a pass-through entity, so instead of paying taxes as a corporation, they actually pay taxes similar to an LLC. Corporate income, losses, deductions, and loans will flow directly to shareholders, avoiding federal corporate taxes.

Shareholders of S Corp will report all financial information related to the business in the respective tax returns and pay taxes at normal income rates. This allows shareholders to avoid the double taxation typically associated with a business.

There are several forms that must be submitted to the IRS for S Corps taxes. The first form is Form 2553, which is the "Election by Small Business Corporation" form. This form demonstrates that the business meets all the requirements set by the IRS to be an S Corp.

Even though S Corp is exempt from corporate income tax, the company still has to file taxes and report its profits to the federal government. This is done with Form 1120-S, which reports the income, losses, dividends and other distributions transferred from the business to the shareholders.


When should a company elect S Corp status?

A small business can save taxes by electing the S corps tax status if the following factors are met:

  • The company complies with S Corp restrictions

  • The business earns sufficient net income to pay a "reasonable salary" and at least $10,000 in annual distributions.

  • The addition of accounting and payroll costs does not exceed the tax advantages.


S Corps Restrictions

The IRS requires that businesses that elect S corps status should:

  • Have 100 shareholders or less

  • Issue a single class of stock

  • Have owners who are US citizens or permanent residents

  • They are owned by individuals and not by commercial entities such as LLCs, corporations, or trust funds.


Net income, reasonable salary, and distributions

To qualify for S-Corps tax status, a business must have sufficient residual income (net income) after running and expanding the business to pay owners:

  • at least $10,000 in distributions.

  • a reasonable salary

Under the S-Corp tax election, entrepreneurs are treated as employees for tax purposes. The IRS requires that employee-owners receive "reasonable wages."

A reasonable salary is any salary you pay someone for doing the same job. 

S-Corps are subject to increased scrutiny by the IRS. It is important that your tasks and your salary match.

In addition to a reasonable salary, it is estimated that distributions should be at least $10,000 per year to generate tax savings for business owners.


Payroll and accounting costs

It is best to leave the accounting and payroll of an S business to a professional. Payroll and accounting for a small business that elects as S Corp is an annual expense compared to tax savings.


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Pat Raskob
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