It is important to understand what exactly is required for S corp certification and what you need to do to operate compliantly.
Setting up a corporation comes with a lot of benefits for the business owners, but can also be a complex process that is ultimately expensive at tax time. For businesses that need the benefits of a corporation but want to avoid double taxation, converting to an S corporation is a great option.
What is an S-Corp?
An S corporation, which can also be called an S subchapter, is a type of corporation that has special tax status under Internal Revenue Code requirements. An S-Corp is not a business entity, it’s a tax classification.
The general structure is the same as a C corporation, but these companies are allowed to pass taxable income directly to shareholders without having to pay federal corporate income taxes. When this happens, the business benefits from the status of a corporation while enjoying tax-exempt privileges associated with other business structures. While S corps have the ability to pass income through to shareholders, they are liable for corporate level taxes on certain built-in gains and passive income.
S corporations must otherwise follow all the rules and regulations of any other corporation. It will be a for-profit company with similar liability protection, ownership, and management structures. This includes observing internal practices and formalities such as having a board of directors, writing corporate bylaws, conducting shareholders’ meetings, and keeping and reporting minutes of significant meetings.
Who should form an S-Corp?
Not all businesses should choose a corporation as their structure, and not all corporations have eligibility to become an S corporation.
Corporations are a better fit for large organizations that may have multiple owners or expect to split duties among many officers. It will also be required for any company that wants to become public and issue or trade stock. However, corporations also offer the strongest protection from personal liability, which may lead people to choose incorporation even if they do not need the structural benefits.
Anyone who forms an S corporation should know they will need to follow the same record-keeping and reporting requirements imposed on a C corporation. This includes writing bylaws and filing annual reports to maintain the status.
Along with normal corporation regulations, only certain businesses can become S corporations.
They must meet the following requirements:
Domestic incorporation within the United States
Have only one class of stock
Have 100 shareholders or less
Only have shareholders who are individuals, specific trusts and estates, or tax-exempt organizations
Advantages of starting an S-Corp
No corporate taxation
The main advantage of an S corporation is for tax purposes. In a C corporation, there is a phenomenon known as double taxation. Double taxation occurs when the company pays corporate tax and the owners pay tax on their share of the profits. Since profits are taxed twice, it’s called double taxation.
S corporations are able to bypass the corporate level taxation, with all profits and losses passing through to shareholders’ personal income taxes.
Reduced taxable gains during selling
For many business owners, the ability to one day sell their business is a goal and potentially even a retirement plan. Because of the unique tax advantages available to S corporations, the taxable gains associated with selling a business are lower than they may be in other business structures. Upon selling an S corporation, no adjustments need to be made to meet complex accounting rules.
Personal liability protection
S corporations offer the same level of asset protection as any corporation. Shareholders are not held responsible for the business’ debts, liabilities, and potential legal proceedings. If the business were to be sued or go bankrupt, the owners would not be responsible for any financial obligations.
Most entities that set up an S-Corp status are corporations or LLCs, which means there is at least limited liability protection. An owner’s personal assets and bank accounts remain separate from that of the business.
Income tax benefits
While there is no corporate taxation on an S corporation, personal income taxes will reflect business income and expenses. However, S corporation shareholders will be able to benefit from other tax changes. The salary or dividends they report can help reduce self-employment tax liability, and start-up costs can often be considered a write-off.
Disadvantages of starting an S-Corp
Expensive startup and maintenance
Before you can operate an S corporation, the business must be incorporated through a state’s formal process. This can include fees for the filing itself, licenses or permits, and other costs. Many states also impose fees annually related to taxes and filing information like annual reports. These are usually deductible expenses, but they are unique to corporations.
Like all corporations, S corporations must hold annual meetings and maintain company meetings. These minutes must be filed as annual reports, which can come with a fee. As S corporations are often smaller, this can be more of a burden on time and resources but is required to maintain legal status.
If mistakes are made regarding the various election, consent, notification, stock ownership, and filing requirements of an S corporation, the company can lose its status and associated tax benefits. This can usually be remedied easily, but may cause other important contracts to lapse, and is not a concern with other structures.
Stock ownership restrictions
While S corporations can have both voting and non-voting shares, they can only have one actual class of stock. This means there cannot be different classes of investors with entitlement to varying dividends or distribution rights. There is also a limit of 100 shareholders and foreign ownership is prohibited. C corporations do not have these same restrictions and have more freedom in their stock structure and ownership.
The limit to one class of stock also means that S corporations cannot easily allocate losses or income to specific shareholders. Instead, this allocation is governed by stock ownership.
Steps to set up an S-Corp
1. Choose a name
Your corporation will need a name that is unique within the state you file in, as well as meeting other state-specific regulations. For example, most states will require you to use a corporate designator like “Corporation” or “Incorporated” at the end of the name. You do not need to register the name, as it will be made official when you file your Articles of Incorporation. If you want to reserve the name until you file, you can usually reserve the name for a small fee.
2. Appoint directors
One requirement for a corporation is to have named directors who will be responsible for decision making on behalf of the company. Directors are expected to take on tasks such as authorizing stock issuance, appointing corporate officers, deciding salaries for officers, and approving loans to and from the business. Typically, the initial owners will appoint these directors, including appointing themselves if they choose.
Most states require only one director for each corporation, regardless of the number of shareholders. However, some states will require the number of owners to be the minimum number of directors.
3. File Articles of Incorporation
The formal paperwork required to incorporate a business within a state is known as articles of incorporation. These will usually be filed through the state department, and some states may use another name like “charter” for these documents. Any owners must sign the articles of incorporation or appoint someone to do so on their behalf. A filing fee is often charged for this process.
Articles of Incorporation ask for basic information including the business address, the names of shareholders, and the name and address of a registered agent.
4. Write corporate bylaws
Separate from articles of incorporation, a corporation must also have bylaws written up. These are internal rules that dictate the processes and operations of the business, including things like when board meetings will occur and what voting requirements are needed to make large decisions. You can use a template to draft these or engage with an attorney.
5. Hold the first board meeting
The board of directors is required to hold an initial meeting to perform some formalities and make decisions at this stage. This includes adopting the written bylaws, creating a fiscal calendar, appointing officers, and authorizing the issuance of the first stocks. It is crucial to take minutes during this meeting, as they will be included in annual reports.
6. Issue stocks
Before any official business can be done, the business will need to issue shares of stock in order to formally divide up the ownership interests. This is a required step before a business can be considered a corporation and offered legal protections. Stock issuance has a variety of laws around how and when it can occur, so it can be helpful to work with an attorney at this stage.
7. Obtain licenses, permits, and zoning clearances
At the federal, state, and local levels, there will be laws around what licensure and permissions need to be obtained before you can operate a business. Be sure you are looking at every level of government, as well as professional organizations related to your industry. The most common form of a business license will be a seller’s permit, which allows you to collect and remit sales tax, but this will differ widely in each instance.
8. File for an EIN
An EIN, or Employer Identification Number, is an Internal Revenue Service (IRS) requirement that is used to track a business. This is similar to the way individuals use a Social Security Number as a tax identifier. Each business will need an EIN in order to employ people and file taxes properly.
9. Designate the company as an S corporation
Once you have an EIN and a formal corporation, you can then take steps to obtain status as an S corp. To do so, you will need to complete and file a particular IRS form, Form 2553, for Election by a Small Business Corporation.
Completion of this form requires the consent of all shareholders and can be submitted in the tax year prior to the year it takes effect, or up to two months and 15 days into that tax year. It will take about 30 days for approval. Once approved, the company officially has C corporation status.
What resources are available to provide further assistance?
Most of what you will need to start a corporation will be specific to your state, with information available through the state department. Below are some resources that you can use to navigate this process.
The IRS provides information on how to form a corporation and handle it when filing an income tax returns.
The U.S. Small Business Association has information on how to register with federal and state entities.
This website has a directory of all Secretary of State offices and websites for easy access.
What does S corp stand for?
An S corp, or S corporation, refers to Subchapter S. This is the section of the Internal Revenue Code that governs this form of business. More specifically, it refers to Chapter 1, Subchapter S – Tax Treatment of S Corporations and Their Shareholders. This title distinguishes S corps from C corps.
Can a corporation become an S corporation?
Yes, S corporations must first be established as a traditional C corporation, LLC, or partnership which can then file for this status. Sole proprietorships and non-profits cannot become an S-Corp.
Do S corps pay any taxes?
The main benefit of an S corporation structure is that corporate taxes are bypassed, with shareholders instead reporting their profits and losses.
Owners still pay federal income tax and file their own personal tax returns, but there’s no corporate tax like there is in a regular corporation.
Can an S corp have only one owner?
Yes, S corporations can be owned by one person or several. A single-member LLC, for example, could qualify for S-Corp status. However, they are limited in the number of shareholders they can have, unlike other corporations.