Start Up Tip: Forming an S Corporation

An S Corporation, also known as an S Corp, is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S Corporation.

An S Corp is a corporation with the Subchapter S designation from the IRS. To be considered an S Corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S Corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits the financial liability for which the owner, or “shareholder”, is responsible. Liability protection is limited. S Corporations do not necessarily protect you from all litigation such as an employee’s tort actions as a result of a workplace incident.

The S Corporation is different from a traditional corporation (C corp) in that profits and losses can “pass through” to your personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. There is an important caveat, however: any shareholder who works for the company must pay him or herself “reasonable compensation.” Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as “wages.”

Forming an S Corporation

Before you form an S Corporation, determine if your business will qualify under the IRS stipulations. To file as an S Corporation, you must first file as a corporation. After you are considered a corporation, all shareholders must sign and file Form 2553 to elect your corporation to become an S Corporation. Once your business is registered, you must obtain the necessary business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing and Permits Tool on the Small Business Administration website to find a listing of federal, state and local permits, licenses, and registrations you’ll need to run a business.

Combining the Benefits of an LLC with an S Corporation

There is always the possibility of requesting S Corp status for your LLC. Your attorney can advise you on the pros and cons. You’ll have to make a special election with the IRS to have the LLC taxed as an S corp using Form 2553. You must file it before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. The LLC remains a limited liability company from a legal standpoint, but for tax purposes it’s treated as an S corp. Be sure to contact your state’s income tax agency where you will file the election form to learn about tax requirements.

S Corporation Taxes

Most businesses need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit. All states do not tax S corps equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. However, some states such as Massachusetts, tax S corps on profits above a specified limit. Other states don’t recognize the S corp election and treat the business as a C corp with all of the tax ramifications. Some states, such as New York and New Jersey, tax both the S corps profits and the shareholder’s proportional shares of the profits. Your corporation must file the Form 2553 to elect “S” status within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect.

Advantages of an S Corporation

• Tax Savings. One of the best features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.

• Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. Nevertheless, if such an employee owns two percent or more shares, then benefits like health and life insurance are deemed taxable income.

• Independent Life. An S corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.

Disadvantages of an S Corporation

• Stricter Operational Processes. As a separate structure, S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.

• Shareholder Compensation Requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results.