What is an S Corporation?
An S Corporation, or S corp, is a type of corporation that meets specific Internal Revenue Service (IRS) criteria to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. This structure allows income to be passed directly to shareholders, avoiding double taxation at the corporate level.
Eligibility Requirements
To qualify as an S Corporation, a business must:
- Be a domestic corporation
- Have only allowable shareholders, which include individuals, certain trusts, and estates, but not partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations
Tax Benefits of an S Corporation
Pass-Through Taxation
One of the primary benefits of an S Corporation is that it offers pass-through taxation. Profits and losses are passed through to the shareholders, who then report them on their personal tax returns. This avoids the double taxation faced by C Corporations, where income is taxed at both the corporate and shareholder levels.
Self-Employment Tax Savings
S Corporation shareholders can be both employees and shareholders, allowing them to potentially reduce self-employment taxes. Only their salary, which needs to be “reasonable” according to IRS standards, is subject to Social Security and Medicare taxes.
Tax-Deductible Expenses
Various business expenses, such as salaries, bonuses, and more, can be deducted to reduce the taxable income of the S Corporation.
Comparing S Corporations with LLCs
Structural Differences
- Legal Formation: LLCs are easier to form and have fewer compliance requirements compared to S Corporations.
- Ownership Flexibility: LLCs can have an unlimited number of members and different classes of membership, whereas S Corporations are limited to 100 shareholders and one class of stock.
Tax Differences
- Self-Employment Taxes: LLC members are subject to self-employment taxes on the entire net earnings, whereas only salaries paid to S Corporation shareholders are subject to self-employment taxes.
- Pass-Through Taxation: Both structures allow pass-through taxation, but the way income is split and taxed can differ.
How to File an S Corporation
Step-by-Step Filing Guide
- Form 2553: File Form 2553, Election by a Small Business Corporation, to elect S Corporation status. This must be done no later than two months and 15 days after the beginning of the tax year in which the election is to take effect.
- Corporate Formalities: Ensure all corporate formalities are in place, including having a Board of Directors and holding regular meetings with minutes.
- State Requirements: Check and comply with state-specific S Corporation requirements, which may include additional filings or fees.
Historical Context
Origin and Development
The concept of S Corporations was introduced by the Small Business Job Protection Act of 1996 to support small businesses, allowing them to gain some of the benefits of corporate structure without the burden of double taxation.
Applicability and Use Cases
When to Choose an S Corporation
- Designation: Ideal for small to medium-sized businesses that wish to benefit from pass-through taxation and avoid double taxation.
- Growth Potential: Suitable for businesses looking to raise capital through the issuance of stock but without the complexities of a C Corporation.
Related Terms
- C Corporation: A C Corporation refers to a legal structure where the owners, or shareholders, are taxed separately from the entity. Unlike S Corporations, C Corporations face double taxation on profits.
- LLC (Limited Liability Company): An LLC is a flexible business structure that blends elements of partnership and corporate structures, protecting members from personal liability while offering various tax arrangements.
FAQs
How does an S Corp differ from a C Corp?
Can an LLC elect to be taxed as an S Corp?
References
- IRS. “S Corporations”. IRS.gov.
- Small Business Job Protection Act of 1996.
Summary
S Corporations offer significant tax advantages, including pass-through taxation and potential savings on self-employment taxes. Understanding the eligibility requirements, benefits, and filing process can help determine if an S Corporation is the right choice for your business needs.
