One of the most common forms of small businesses is the Subchapter S corporation. Learn what it is and how it’s taxed here.
What is an S Corp? It is a small company that files eligibility for a special tax designation status that does not pay federal corporate income taxes. Every income and loss is passed to each shareholder, who becomes individually responsible for reporting the income, deductions, losses, and credits in their tax returns.
S Corps are common among small businesses because they immediately provide them with a corporation's benefits while exempting them from the tax responsibilities of a business partnership. There are specific Internal Revenue Code rules that a company must meet before becoming an S Corp.
Here is a detailed overview of what you need to know about S Corps, how they work, and whether they are an excellent choice for your business structure.
As mentioned, an S Corp is a business structure that annually passes the income, deductions, tax credits, and losses through to the shareholders. The business income is distributed among the shareholders' tax-free, and the shareholders are taxed under personal income tax returns on Form 1040. However, the S Corp is still required to file for an informational tax return called the Form 1120S.
Usually, the shareholders are individuals, certain trusts, estates, partnerships, or other tax-exempt charitable organizations. According to the IRS, any shareholder who works for the S Corp should take a salary and report the employee salary under form W2 and the shareholder investments under form K on the 1040 form.
While the amount of salary a shareholder pays is subject to some freedom of allocation, it should match the current market equivalent for the executive position. The S Corp deducts the payroll expenses, but the IRS assesses business income to determine penalties, employment taxes, and interests and conducts audits on S Corps where salary is not paid.
The S Corp status is canceled when a business fails to meet the eligibility requirements outlined by the IRS. If the company was late filing for eligibility at the beginning of the taxable year, the business is taxed as a corporation instead of an S Corp.
When answering “What is an S Corp?” it is equally important to understand the meaning of S Corp. S Corp stands for Subchapter S Corporation or Small Business Corporation.
To be taxed under an S Corp, a company must first be elected under Chapter 1 of the Subchapter S of the Internal Revenue Service (IRS). Since this status prevents businesses from double taxation (that is, at the corporate and the individual level), the tax rate becomes dependent on the tax bracket of the shareholders.
Every state offers different S Corp rules. For instance, while some states like New York City don't allow for any tax break, even under an S Corp status, others only require the business to file for a state-specific form to achieve eligibility.
Congress enacted S Corps in 1958 to encourage small and family businesses and offer support by removing the double taxation that is subject to conventional business corporations. Before deciding to submit your company for S Corp status eligibility, look at its pros, cons, and requirements for S Corp status eligibility.
Except for specific passive income and capital gains, an S Corp does not pay any federal income tax. Instead, all the revenue, profits, and losses pass through to the shareholders of the business. Taxation then happens at the shareholders' level under individual tax rates. As such, every profit made by the corporation is only taxed once.
This exemption means that you will not pay a double tax on your dividends with an S Corp.
Once you sign your business under an S Corp, your personal assets become protected legally and separately from the business assets. For instance, if the S Corp goes into debt, you are not made personally liable even if you are the company's sole owner.
This also means that your creditors will not come after your personal assets. Instead, the investment you put into the business will only be part of the debt recovery.
An S Corp gives you the freedom to characterize your income as wages or dividends for tax purposes. For instance, if you are a shareholder, you file for tax as an employee with a salary (that you pay yourself).
In addition, you file for taxes on your paid dividends from the S Corp, which are generally tax-free or taxed at a much lower rate compared to employee salary.
As long as you are reasonable and meet the eligibility requirements, you'll reduce your self-employment tax liability.
Transferring ownership interest from one shareholder to the next doesn't cause significant tax consequences or threaten the termination of the entire S Corp because the company structure offers shares of stock.
Also, you will not be required to comply with complicated accounting rules or make adjustments to the property basis.
Usually, corporations should use the accrual method of accounting if income is at least $5 million. But with an S Corp, you can use the cash method of accounting if you don't have inventory to report.
Here, you tax earnings when received and deduct cost when issued. Thus, removing and managing money is more manageable, especially for the employment taxes paid on salaries.
Any shareholder in an S Corp is fully committed to the business. Potential employees, customers, business partners, or financial organizations consider S Corp more credible than other forms of corporations.
Starting an S Corp status requires following numerous protocols like scheduling meetings with all shareholders and directors, maintaining records properly, and meeting the formalized by-laws.
The cost of forming and maintaining an S Corp is high compared to partnerships and sole proprietorships since the latter are exempt from annual report fees and franchise taxes, among other expenses.
As long as your business is an S Corp, it must use the Calendar year as the tax year. The only exemption is when business owners provide a viable reason for having a unique fiscal year.
Compared to corporations like C Corps, the ownership structure of an S Corp is less flexible. For instance, you can only have one class of stock when under an S Corp. This might deter some investors from taking an interest in your business. Additionally, no shareholder should be foreign or from specified corporate entities of trusts. The total number of shareholders is also limited to less than 100.
As mentioned, the IRS conducts audits and assesses S Corps for payment and taxation mistakes. Therefore, expect the IRS to ask you to re-characterize your wages and dividends, affecting your overall employee salary taxable amount.
Even though this is not a common occurrence, some business owners make mistakes when filing the IRS requirements form for the S Corp election and stock ownership, among other errors. If this happens, your business will lose its S Corp status.
All profits and losses in an S Corp must be shared equally with each shareholder because the corporation only has one class of stock.
Because the S Corp is entirely separate from its owners, every shareholder enjoys limited liability protection given to a corporation, which means they are not liable for any business debts. As such, all personal assets that belong to your shareholders, like cars, houses, and bank accounts, will not be subject to business credit.
Instead, if each shareholder contributed $20,000 to start the small business, that is the total amount the creditors will consider liable for collection. Suppose your company has five shareholders meaning the entire amount contributed at the start of the business was $100,000.
If the business incurs a debt of $150,000, creditors will only take the $100,000 from your shareholders and leave the remaining $50,000 since your personal property is protected in an S Corp. But certain conditions allow shareholders to be sued and held personally liable, meaning creditors can take the shareholders' assets. These are:
This includes fraud or any wrongful rendering of services or products. For instance, if one of your shareholders knowingly sells defective products, the court removes their limited liability protection and holds them personally responsible for compensation.
Other wrongful instances are assault and business misrepresentation during loan applications. During criminal acts, if it is determined that the individual was acting in the interest of your business, your entire corporation is held liable.
Suppose any of your shareholders have signed a personal guarantee for a loan. In that case, the individual becomes the party to the contract by giving up their limited liability protection.
Therefore, any debt not paid by your business becomes the legal responsibility of this shareholder. The same thing happens if you sign your business contract in your name instead of the business name.
If your shareholders combine business and personal financial accounts, the court might pierce the corporate veil that lets creditors hold each shareholder responsible for the business debts.
Such instances are shareholders using business accounts for personal use like paying personal bills. - piercing the corporate veil takes away limited liability protection.
It is not uncommon for courts to deem the S Corp’s veil., This means meaning all your shareholders become personally responsible for the S Corps debts if it fails to follow the requirements and formalities of achieving the S Corp status. These include requirements like adopting corporate bylaws, holding annual meetings, and keeping accurate minutes.
Therefore, always ensure that your business and shareholders fulfill all the requirements of an S Corp throughout the year.
Now that you know the answer to “What is an S Corp,” the next step should understand how to form one. For your business to become an S Corp, it must first become an LLC or a C-Corp. File articles of incorporation with your Secretary of State to become a C Corporation or start a Limited Liability Company.
That is, choose a business name, register for an employer identification number (EIN), and select the shareholders for your business. Then register the company by filing for the articles of incorporation. Usually, the filing fee ranges between $100 and $800, depending on your state.
Also, share the stocks equally among the shareholders and get the required permits and licenses. Now that the state recognizes your LLC or C Corp, start to ensure your business qualifies for the S Corp status based on the IRS requirements.
Your company must meet the following criteria before qualifying for S Corp status:
After your business qualifies for all these requirements, file for IRS Form 2553, download a copy of the form on the IRS.gov website, then start to fill out the four parts of the form. The first part requires the election information of your business. That is your business's name, address, EIN, and incorporation date.
You should also include your IRS corporate officer's name and contact information and the tax year your company intends to hold. The timeline for filing the form is two and a half months after the beginning of your tax year.
That is March 15th if your tax year is the calendar year beginning on January 1st. In addition, add the names, addresses, security numbers, signatures, and shares for each shareholder.
In the second part, you can choose to change your tax year. But only a few cases allow for filing under a non-calendar tax year, for instance, if you make section 444 tax payments or have a different natural business year.
In the third part, file for qualification for the S Corp by listing the name, social security number, address, and trust's name of the income beneficiary. Also include their EIN and address. The fourth part is for any business filing for the S Corp status past the IRS deadline.
Since you cannot file for Form 2553 electronically, fax the original completed form to your nearest Internal Revenue Service Center.
Remember, the period you choose to file Form 2553 will determine your fiscal year and whether your business will be granted S Corp status in your intended year or a later year – it happens with late filing.
Expect a verdict on your application within 60 days of submission or call the IRS to get a status update.
When first choosing your business structure, the two primary options are either a corporation or an LLC. If you choose to create your business as a corporation, you determine whether you want it taxed as an S corporation or a C corporation. If you choose to have your business as an LLC, you decide whether or not you want it taxed as a sole proprietorship, a partnership, an S corporation, or a C corporation.
Generally, the LLC is a legal entity with low maintenance. The S Corp is a tax status designed to help businesses save on taxation. The C Corp is a legal entity that's more complicated and designed to keep the profits in the business.
The LLC pays standard taxes, the S Corp is not taxed on the business dividends, and the C Corp is under double taxation. As such, you can reinvest profits with a C Corp but not with an LLC and the S Corp. Unlike corporations, an LLC has no shareholders.
Nonetheless, an S Corp can only have up to 100 shareholders, while a C Corp can have an unlimited number of shareholders. Additionally, the LLC is the most flexible of the three business structures regarding the management, profit sharing, and taxation option.
For instance, if your business is a corporation, you cannot choose to be taxed as a partnership or a sole proprietorship. Still, you can also consider taxing your business as an S Corp or a C Corp with an LLC business structure.
On the other hand, corporations have an easier time getting outside investments from banks or investors. This makes corporations the best business structure to choose if your future business goals include conducting an initial public offering or attracting venture capital.
But these options work best for a C Corp and not an S Corp since an S Corp has IRS restrictions like the type of stock or number of shareholders the business can have that deter potential investors.
As a business owner, two things to keep in mind when choosing your business structure include the protection of personal assets and tax advantages. Whether the LLC, S Corp, or C Corp can be a good option when considering the former. But when considering the latter, consider either the S Corp or the LLC since they both offer pass-through tax advantages.
Another thing to consider is how your choice will affect your business in 5 to 10 years. Take the comparison between an S Corp and a C Corp, for instance. With an S Corp, you know you will save money on taxes since you're exempt from double taxation, but in five years, you might be limited when considering business expansion since you can only have 100 shareholders and one class of stock. Additionally, you can grow your C Corp internationally, but an S Corp has to remain domestic.
Therefore, if you want your business to go public in the future and you are okay with double taxation, a C Corp would be the best option. On the other hand, if you don't mind a limited number of shareholders or extra scrutiny from the IRS, then you can settle for an S Corp.
To determine whether a business is under the S Corp status, look at the business structure and the growth potential. The S Corp must fulfill IRS requirements like remaining domestic and not having more than 100 shareholders in terms of structure.
And when considering business growth potential, it isn't easy to take an S Corp public or expand it to international markets or get investor funding because of the domestic and one-stock nature of the S Corp status.
Now that you know what is an S Corp, if you aim to start a small painting business in your local region, contact Hoist to help you start, run, and grow your business. Hoist offers training, support, brand building, lead generation, and business management hassle-free and at an affordable rate.
Sources:
Form 1120-S: US Income Tax Return for an S Corporation Definition | investopedia.com
Form 1040: US Individual Tax Return Definition | investopedia.com
Form 2553 (Rev. December 2017) | irs.gov
Publication 538 (01/2019), Accounting Periods and Methods | Internal Revenue Service
Cost to Incorporate or Form an LLC | USA Corporate
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