Heads up: this article is only relevant for U.S. businesses.
Not to be confused with the C corporation, the S corporation is a unique business structure that provides access to significant tax benefits.
Before we guide you through the steps you need to take to form an S corporation, let’s examine the advantages and disadvantages of the S corporation business structure.
Advantages of the S corporation
S corporation shareholders are required to report “the flow-through of income and losses on their personal tax returns.” Shareholders are assessed tax at their individual income tax rates. This system allows S corporations to avoid double taxation on the corporate income.
Because of this unique setup, the S corporation offers a few unique advantages.
One of the main advantages of the S corp is the specific tax regulations that come with the structure. Only the wages of an S corporation shareholder who is an employee are subject to employment tax, while the remaining income is paid to the owner as a “distribution.” These distributions are taxed at a lower rate (the shareholder’s income tax rate) than salary, if at all.
Reduced tax payment if you sell
If the time comes to sell the business, you’d pay a lot less in taxes as an S corp vs. a C corp due to double taxation regulations.
Long life expectancy
The S corporation is an independent entity. As such, the company’s life expectancy is longer as a result of this independence, and there’s minimal disruption if a shareholder leaves.
Disadvantages of the S corporation
As with any business structure, the S corporation also has a few downsides.
Limit on shareholders
One S corporation rule that poses a potential drawback is the limit on the number of shareholders; companies formed as an S corporation aren’t allowed to have more than 100 shareholders. For this reason, the S corporation isn’t a good choice for companies who plan to significantly expand their shareholder base, or for those companies who intend to go public. Publicly traded companies often have thousands or millions of shareholders, which disqualifies the S corporation business structure as a viable option.
Wages are monitored
The IRS keeps an eye out to be sure no one is using the S corporation tax advantages for unfair gain. One of the ways they do this is by requiring shareholders who are also employed by the company to pay themselves a reasonable compensation, which is judged based on fair market value for a similar position. The IRS keeps a close eye on whether owners are receiving fair compensation. If the IRS suspects the owner/shareholder has misreported wages, they may reclassify additional corporate earnings as wages, which could increase the shareholder’s tax payment significantly.
How to form an S corporation
In order to elect S corporation status, your business must first be structured as a C corporation.
Your business will also need to meet certain IRS requirements before you can elect to change its legal structure.
Before transitioning to an S corporation, your company must:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)
Finally, the corporation must submit Form 2553 Election by a Small Business Corporation, signed by all the shareholders.
After you’ve made this change, you’ll need to obtain all relevant business licenses and permits, which vary by state.
Check in with your state
While tax advantages make the S corporation an attractive business structure, S corporations aren’t treated equally by each state government. For instance, some states choose to follow the federal tax requirements for S corporations, while others ignore the S corporation status and tax the company as a C corporation.