If you’re considering filing for corporate status, you probably already know that not all corporations are the same. There are S corporations, C corporations, nonprofits, and—though it’s subject to some dispute—limited liability companies. Many businesses strive for S corporation status because of the tax advantages, but not every business is ideal or even eligible for this type of status. Before filing, it’s important to understand the specifics.
What Is an S Corporation - An Overview
In its simplest terms, an S corp is a corporation that’s exempt from paying corporate income tax. The term is short for “Subchapter S Corporation” or “Small Business Corporation.” Rather than paying a traditional corporate tax, this type of organization divides its profits and losses among its shareholders. The income, credits, and deductions are reported on the shareholders’ personal tax returns.
“S corporation” is not a type of business entity, but rather a tax designation assigned by the Internal Revenue Service. To become an S corp, you must first file and structure your business as a C corporation or LLC and then apply for S corp status. C corp and LLC filings are handled at the state level; S corp applications are handled at the federal level.
S-corp status is often attractive to small businesses because it eliminates the problem of double taxation. If your business and personal finances overlap, you don’t want to be taxed on the same money on both your personal and corporate tax returns.
The Benefits of Becoming an S Corporation
As noted before, S corporations don’t pay federal corporate tax. They pay employment tax on employee wages and sometimes state taxes. That’s why many small businesses favor this type of corporate structure. It only becomes a potential disadvantage if you’re both an employee and a shareholder. In those cases, you’re required to pay yourself a reasonable salary before qualifying for tax-free distribution.
The IRS does not define what constitutes a reasonable salary, but it should be a wage that falls in line with the experience, responsibilities, and skill level required of the job. Look at it this way: If the IRS were to audit you, would you be able to adequately defend the salary you pay yourself?
Aside from the tax benefits, there’s one other distinct advantage of electing for S-corp status. If you ever decide to sell your corporation, the taxes on an S-corp sale are far less than the taxes on a C-corp sale.
Do You Qualify as an S Corporation
Once your corporation is up and running, you have to determine if your business qualifies for S-corp status. Simply having a corporation isn’t enough. You have to meet a few specific criteria:
Your business must be registered with the state as either a C corporation or LLC with all filings and dues up to date.
Your business must be based in the United States.
Your business must consist of no more than 100 shareholders.
All shareholders must consent to the S corp status.
Your business must consist only of allowable shareholders—in other words, none of the shareholders can be non-residents, partnerships, or corporations unto themselves.
Your business must have only one class of stock shares.
Banks, insurance companies, and domestic international sales corporations are not eligible.
How to Become an S Corporation
If your C corporation has been created and you’ve confirmed that it meets all of the IRS’s eligibility criteria, you’re ready to file for S corp tax status.
You’ll need to file IRS Form 2553, Election by a Small Business Corporation. This four-page application must be signed by all shareholders within your corporation, and it includes four parts:
Election Information: You’ll need to provide your general company information as well as information about all of the shareholders in your company.
Selection of Fiscal Tax Year: You’ll need to answer a few financial questions pertaining to the business’s tax year.
Qualified Subchapter S Trust (QSST) Election: This section is specifically intended for trusts applying for S-corp status. It asks for the income beneficiary’s personal information as well as general information about the trust itself. If your operation doesn’t qualify as a trust, you can skip this section.
Late Corporate Classification Election Representations: This section is intended for companies filing after the IRS deadline. In general, corporations are required to file no more than two months and 15 days after the start of their tax year if they wish to qualify for S-corp status in the same year.
If your business is an LLC, you’ll first need to file IRS Form 8832 and select your entity as “A domestic eligible entity electing to be classified as an association taxable as a corporation” (6a). Once you elect to be taxed as a corporation, you can then file Form 2553 to apply for S-corp status.
Is an S Corporation Right for You?
An S corp comes with many advantages, and it's definitely worth the effort—for certain businesses.
With that said, it’s not the ideal structure for everyone. For example, the requirements are very strict, and if your business fails to meet those requirements at any point, the IRS will immediately revoke your S-corp status and tax you as a C corp. This can be enormously painful and costly. So if, for example, your business is growing and you anticipate that you’ll exceed 100 shareholders at some point, the S corp status probably isn’t for you.
Additionally, the IRS applies heavy scrutiny to S corps. If the IRS has any concerns about the “reasonable salaries” that officers pay themselves, you may have an auditor at your door. This is an important factor to be aware of.
Finally, it’s important to understand how corporations are governed in your state. State driven laws can be significantly different from state-to-state.. This could mean additional taxes that you don’t want to pay.
So should you file as an S corp? If you live in a state or location that’s S-corp friendly, and you meet all of the criteria as a small business, this type of filing can be enormously advantageous. Weigh the pros and cons, and speak with a knowledgeable CPA firm if you need help deciding on the best structure for your business.