If you run a small business with 100 or fewer shareholders, consider forming an S corp (or S Corporation). An S corp is a tax classification that can save you money as you grow your business.
Like limited liability companies (LLCs), S corps are pass-through entities, meaning you don’t pay corporate taxes. Instead, S corps can pass corporate credits, deductions, income, and losses to their shareholders for federal tax purposes.
However, S corps aren’t suitable for everyone. Before you elect to become one, here’s what you should know:
What are Corporations?
Corporations are business entities that have directors, officers, and shareholders, and each has a role to play:
- Directors make major decisions, oversee company strategy, and represent shareholder interests
- Officers run the day-to-day operations
- Shareholders own stock in the business
Corporations are legally separate from their shareholders, so you’re not personally liable for the company’s debts if you’re a shareholder. Instead, your liability is limited to your investment.
Corporations also have specific legal obligations, like conducting regular meetings and stringent record-keeping. Other business structures, like LLCs and sole proprietorships, don’t require this.
What is an S Corp?
S corps get their name from Subchapter S of the Internal Revenue Code. While S corps fall under the corporate business entity umbrella, they’re exempt from paying federal corporate income taxes. Instead, you get taxed on the income you receive from dividends at the individual level based on your marginal income tax rate.
If you’re an S corp shareholder meeting specific criteria, you can offset corporate losses with income you receive from other sources on your personal tax return. C corp shareholders lack this tax benefit. They have to pay personal income tax on dividends at their marginal tax rate after the corporation’s profits are taxed at the corporate rate (a.k.a. “double taxation”).
Requirements for Forming an S Corp
To qualify, you have to submit Form 2553, Election by a Small Business Corporation with all your shareholders’ signatures. You must also:
- Be a domestic corporation
- Be an eligible corporation*
- Have 100 shareholders or fewer
- Have only one class of stock
- Only have allowable shareholders (e.g., individuals, estates, certain trusts)
*You cannot form an S corp if you’re an insurance company, a domestic international sales corporation, or certain financial institutions.
Pros and Cons of S Corporations
S corps come with several benefits and drawbacks. Let’s start with the benefits:
S Corp Benefits
- Pass-through taxation: S corps don’t have to pay federal taxes at the corporate level, which can save you a lot of money. Newer companies, in particular, can benefit from this.
- Personal tax benefits: As an S corp owner, you can reduce your personal income tax burden. You can also decrease your self-employment tax liability by receiving income as a salary or dividends.
- Reduced Social Security and Medicare taxes: If you’re an S corp owner who is also an employee, you pay taxes based on your compensation rather than on the company’s net earnings.
- Limited personal liability: Shareholders can’t be held personally liable for the S corporation’s actions. Your personal assets are protected if the S corp files for bankruptcy or has creditors looking to collect.
- Dividend benefits: If you’re a shareholder and an employee, you can receive tax-free corporate dividends based on your stock basis (your initial invested value). If your dividends exceed this, the excess gets taxed as capital gains, which is still typically lower than the ordinary income tax rate.
- Asset transfers, simplified: Avoid adverse tax outcomes and convoluted accounting requirements when transferring interests or adjusting your property bases.
- Bolstered credibility: Having an S corp is like having a status symbol in the business world, and it can boost credibility with clients, investors, vendors, and employees.
S Corp Drawbacks
- Time-consuming filing process: You can’t elect to become an S corp overnight. As the business owner, you must file your Articles of Incorporation with the Secretary of State, select a registered agent, appoint a board of directors to govern your company, hold regular meetings, and keep records of your meeting minutes.
- Startup and recurring fees: Forming and maintaining an S corporation isn’t free. Depending on your location and industry, you’ll have to pay incorporation fees, annual report fees, and other miscellaneous fees.
- Growth limitation: S corps must have 100 shareholders or fewer. If you’re growing rapidly and want to attract venture capital and more prominent investors, you may find yourself stifled.
- Strict distribution rules: As an S corp, you lack flexibility when allocating profits and losses to shareholders. Your distributions are tied to the number of shares or owner percentage of each individual shareholder.
- Increased admin burdens: S corps have more requirements than partnerships and LLCs to remain compliant, including annual board and shareholder meetings.
- Increased IRS Scrutiny: Before making any distributions, you must pay your shareholder-employees a reasonable salary. The IRS pays close attention to this because S corps can categorize salaries as corporate distributions to evade payroll taxes.
- Risk of removal: If your S corp fails to distribute profits and losses properly or has other noncompliance issues, like errors in filing requirements, elections, stock ownership, etc., the IRS may revoke your Subchapter S status.
How to Start an S Corp
Forming an S Corp may seem like a straightforward process, but we strongly recommend working with a business attorney to make sure you’ve done everything right.
1. Select Your Business Name
Start by conducting a business name search on your Secretary of State’s website and county clerks’ offices. If you plan to do business in other states, visit their respective Secretary of States’ websites as well.
When choosing a name, you must include “corporation,” “incorporated,” “inc.,” or an abbreviation thereof.
2. Apply for Your Employee ID Number (EIN)
The IRS requires businesses that operate as corporations to have an EIN. An EIN is a nine-digit number assigned to your business for tax purposes. You can apply for one online.
3. Choose Your Registered Agent
Your registered agent is a person or business entity responsible for receiving your S corp’s legal and financial documentation. They must have a physical address in the state where you’re forming your LLC, not just a P.O. Box.
After you form your S corporation, your registered agent’s address becomes public. If you’re concerned about sharing your personal information with the world, you can use a commercial registered agent service instead.
4. Register Your Business as a Corporation
To legally incorporate your business, file your Articles of Incorporation with your state. While not required, you should also have an operating agreement. We strongly recommend working with a business attorney on both of these documents. If there are any errors or the terms and conditions are unclear, member disputes can wreak havoc on your business — especially when the courts end up making decisions for you.
5. Obtain S Corp Status
Once registered as a corporation, you must file Form 2553, Election by a Small Business Corporation (as mentioned in the requirement section of this article) with the IRS. Upon approval, you now have an S corp!
Alternatives to S Corps
S corps have many advantages but are only one of several legal business structures. Here are a few others that might be a better fit:
LLCs
An LLC is a business structure, whereas an S corp is a type of tax classification. Both LLCs and S corps enjoy limited liability protection and pass-through taxation.
LLCs enjoy more operational and profit distribution flexibility than S corps. Still, S corps have more tax benefits, like allowing owners to be paid a salary and receive dividends, which can reduce their self-employment taxes.
Unlike S corps, where ownership is represented through stock shares, LLC owners are called “members.” LLCs can be member-managed or manager-managed, depending on the operating agreement. These are just a few of the differences between LLCs and S corps.
Sole Proprietorship
You and your business are considered the same entity in a sole proprietorship. It is easy to set up, and you’ll have operational autonomy because you’re the only one in the business.
While you’ll enjoy the same tax benefits as an LLC, you’re personally liable for anything that happens to your business. While S corporations cost time and money to set up, the tax benefits, liability protection, and enhanced credibility are often worth it.
Partnerships
A general partnership is like a sole proprietorship but consists of two or more individuals or entities. Each partner shares in your business’s profits, losses, and management. You are also personally liable for the debts and obligations of your partnership (unless you form a limited liability partnership).
Is Starting an S Corp Right For You?
Forming an S corp is a huge decision that can have a short- and long-term impact on your business going forward. You’ll enjoy many benefits as a corporation without experiencing double taxation. However, the limited number of shareholders allowed can bring a fast-growing company to a halt.
Whether you select an S corp as your tax classification or opt for something else, make sure your contracts are legally sound. At Exordium Law, we understand Washington’s legal complexities. We’re here to guide you through every phase of business growth while providing the legal guidance you need to thrive. Let’s work together to lay a strong legal groundwork for your business.