S Corporation: Definition & Overview

KEY TAKEAWAYS

• S Corporations are legal business entities that come with a number of tax advantages.
• Becoming an S Corporation means meeting the strict requirements set by the IRS.
• Most S Corporations function the same as other corporations. The only difference is the limitation on shareholders. 

What is an S Corporation?

An S Corporation is one of the many business structures you can form in the United States. It is sometimes referred to as an S Subchapter. An S Corporation is a corporation status that meets specific IRC filing requirements. IRC stands for Internal Revenue Code.

If a corporation meets the filing requirements, they are able to pass business income directly to shareholders. However, they can also pass along other credits, deductions, and losses as well. They can do this without having to pay federal corporate taxes. 

Corporation shareholders love this, and you may find that you appreciate the income tax benefits. Indeed, there are tax advantages and more. But for the most part, S Corporations associate with small business entities.

Because an S Corporation is a legal entity, certain requirements are in place to become one. Explore the requirements below:

• All S Corporations must be domestic corporations
• Can only have one class of stock
• Must have allowable shareholders
  • Individual shareholder, certain trusts, and estates
  • May not be partnerships, corporations, or non-resident shareholders
• Can have no more than 100 shareholders
• Cannot be an ineligible corporation
  • This includes certain financial institutions, insurance companies, international sales corporations

Understanding S Corporations

S Corporations get their name from Subchapter S of the IRC. This is the chapter that defines the way that they want to be taxed. As stated previously, S Corporations can pass specific business financials directly to shareholders. This includes business income, losses, deductions, and credits. Because of this, they are sometimes referred to as pass-through entities. This is because they participate in pass-through taxation.

S Corporations are liable on the corporate level for taxes, though. This includes taxes on specific built-in gains and passive income. 

S Corporations are Similar to C Corporations

The only thing that makes an S Corporation unique to other corporations is its tax status. An S Corporation is a for profit corporation. It’s incorporated and governed under the same corporation laws in the state it is in. It still offers owners limited liability protection, as well.

Like any other corporation, an S Corporation still has to operate in a similar manner. This entails having a board of directors and writing corporate bylaws. It also means conducting shareholder meetings. Minutes for meetings are in place, as well. Again, the only unique factor is the S Corp status.

How Does a Company Become an S Corporation?

To become an S Corporation, a company must first be an incorporated business. After incorporating, a business must then meet all of the criteria listed above. If it does, it can then fill out Form 2553 with the IRS. This form is officially known as “Election by a Small Business Corporation.”

If business owners want to be an S Corporation, all shareholders must know. If a shareholder disagrees with becoming an S Corporation, the process stops. However, if all shareholders agree, then they can sign consent forms and submit them with Form 2553. The IRS then processes these documents, and the corporation becomes an S Corporation.

Just be sure to submit the proper documentation to the federal government. You’ll also need to look into self-employment taxes. Keep in mind that there are special rules for all structure types. If you’re looking for the simplest structure, you want to be a sole proprietor.

Any type of corporation comes with more responsibilities. The S corp status corporate structure has corporation election and other eligibility requirements.

The Advantages of Filing as an S Corporation

There are a number of great advantages to filing as an S Corporation. We’re going to review them one by one below.

Tax Status

The most significant advantage of filing as an S Corporation is the tax status. S Corporations enjoy all of the benefits of incorporation, and get taxed as a limited liability partnership. This means that tax costs are much lower for the entity as a whole.

Pass-Through Taxation

All shareholders are able to report earnings on their taxes as personal income. This is because the profits and losses passed to shareholders get characterized as salary or dividends.

Avoids Double Taxation

Because all profits and losses get reported as personal income, double taxation is avoidable. This presents a significant financial advantage to all shareholders. You should note, though, that shareholders may have to pay capital gains taxes. This occurs when a shareholder is an employee who receives dividends that exceed their stock basis. Still, these get taxed at the lowest possible rate, especially when compared to income tax.

Opportunities for Investment

Because an S Corporation holds stock, it can attract potential investors through the sale of shares. This can put more money into a business, allowing them to expand and grow. Overall, this would increase the business’s chance of success over time.

Continued Existence

When a small business becomes a corporation, the business can continue to exist if the owner leaves or dies. This allows the other stakeholders to continue the business in the event that something happens to remove the owner from the picture. 

Less Strict Filing Requirements

Alongside having an advantageous tax status, the tax filing requirements are more relaxed. An S Corporation only has to file taxes once a year. A standard C Corporation has to file taxes quarterly. This is less time intensive for the S Corporation, and less costly.

The Disadvantages of Filing as an S Corporation

While there are significant advantages to filing as an S Corporation, there are also disadvantages to consider. It’s important to weigh the pros and cons against each other carefully.

S Corporations Require Citizenship

One of the most distinct disadvantages is the limitations on becoming an S Corporation. Only US citizens can file to become an S Corporation. Anyone, regardless of status, can file to be a C Corporation or Limited Liability Partnership.

Limited Ownership

When you file to become an S Corporation, you place a limit on how many owners the corporation can have. S Corporations can have a maximum of 100 shareholders. This can limit investment opportunities, especially if you’re close to the shareholder cap.

Higher Ongoing Expenses

As an S Corporation, you may be subjecting yourself to higher expenses over time. This is because you have to pay to incorporate, then pay the required fees. Then, you have to file to be an S Corporation, which takes more time and money. Additionally, many states require S Corporations to pay ongoing fees. These can include annual report fees, or franchise/tax fees. 

More Involvement with the IRS

Because of the modified tax status, S Corporations are more likely to have more IRS involvement. This is due to the way that payments get distributed to employees and shareholders. They can submit as salary or dividends. This causes the IRS to review the financial information from S Corporations in a more detailed manner.

Complex Qualifications

The qualifications to become an S Corporation are certainly complicated. If a company makes any mistakes regarding their financial information, they may have their status removed. This can create large financial problems for the business itself. It is highly recommended to hire a financial professional to help you maintain all requirements.

S Corporation or Limited Liability Company (LLC)?

On the surface, S Corporations and LLCs are very similar. Both are pass-through entities, and both offer limited liability protection. That said, LLCs tend to be easier to form. They don’t have any regulations when it comes to shareholders or owners. They can also distribute profits and losses however they want to. This flexibility is a major advantage over an S Corporation.

The largest issue with forming an LLC is the ability to obtain funding. Many financial institutions will not provide funding to LLCs. This limits the potential for growth for LLCs. 

Summary

Your business’s financial health should be your focus. You need to consider how it impacts the other two elements of the triple bottom line. But you also need to think about your profitability and how this impacts your company in a social and environmental way.

The key here is that all three are interconnected. Suppose you run a company that relies on manufacturing for its products. You want to make sure that the processes involved in making those products are ethical and sustainable. 

You might also want to take into account where the materials come from. Are there any negative consequences on the environment or people when making your products?