S-Corp: What is it and Should You Get One?

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Estimated reading time: 10 minutes

When it comes to starting a business, entrepreneurs have a number of different options. There are sole proprietorships, general partnerships, LLCs, and corporations.

But out of all the business entities available, corporations are the most dynamic. This is because they offer tremendous flexibility and advantages as well as asset protection and limited liability protection. Corporations are also the most secure because the law considers it a ‘person’ with rights. This means that a stockholder (owner or partial owner) is a holder of shares of stock in the corporation and is not in legal danger for the acts of the corporation.

There are several types of structures within this entity, but the top two are an S-corp (for tax purposes) and a C-corporation. In this blog post, we’ll walk you through what an S-corp is and why it’s a smart choice for small business owners.

What is an S-corp?

An S corporation, also referred to as an S subchapter, is a type of corporation that meets specific Internal Revenue Code requirements. If it does, it may pass income (along with other credits, deductions, and losses) directly to shareholders, without having to pay federal corporate taxes. The advantages of electing this type of tax election are far reaching. We will explain these advantages in the next section.

Usually associated with small businesses (100 or fewer shareholders), S corp status effectively gives a business the regular benefits of incorporation while enjoying the tax-exempt privileges of a partnership. In short, an S-corp is a type of tax status that comes with tax benefits.

Advantages of an S-corp

From tax advantages to flexibility, forming an S corp has many benefits. One such benefit is pass-through taxation. This allows owners to avoid the double taxation (or paying twice on corporate income) of C corps making it a popular choice for small business owners.

Both S and C corps allow for limited liability of the owners, officers, and directors but while C corps have no limitations on shareholders, S corps cap the number of shareholders at 75.

These shareholders report income, gains, and losses from the corporation on their individual tax returns, and pay taxes at their ordinary income tax rates. Since the money comes to them free of corporate tax, they avoid double taxation on any income or earnings.

Disadvantages of an S-Corp

Because S corporation owners will sometimes disguise salaries as corporate distributions to avoid paying payroll taxes, the Internal Revenue Service (IRS) heavily scrutinizes how S corporations pay their employees. Owners of S corporations must pay reasonable salaries to shareholder-employees for services rendered before any distributions are made.

Additionally, when it comes to making those distributions to stakeholders, the S corp must allocate profits and losses based only on the percentage of ownership or number of shares each individual holds.

If an S corp doesn’t do this—or if it makes any other noncompliance moves, like mistakes in an election, consent, notification, stock ownership, or filing requirement—the IRS could terminate its Subchapter S status. This happens rarely, though. Usually, a quick rectification of non-compliance errors can avoid any adverse consequences. 

Finally, there are stricter qualifications that the corporation must meet to elect S corporation status. To qualify for S Corp status, your business:

  • Must be a domestic corporation formed in the U.S.A.
  • Can have no more than 75 shareholders.
  • Only individuals, estates, or certain trusts can be shareholders.
  • No non-resident alien shareholders.
  • May only have one class of stock.
  • Must be a small business corporation, financial institutions (i.e. banks, insurance companies, building and loan associations, mutual savings, and loan associations) cannot take advantage of an S corporation election.
  • Must conform to state statutory restrictions, which limit the transfer of shares/ownership of the company.

To be more specific, S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations (501(c)(3)). Partnerships, corporations, and nonresident aliens cannot qualify as eligible shareholders.

Pros

  • Allows for limited liability of the owners/officers/directors
  • Typically runs on a calendar year
  • Full disclosure of corporate owners
  • Pass-through taxation

Cons

  • Limited number of shareholders
  • Shareholder restrictions
  • Stricter criteria
  • Potentially growth-inhibiting qualifications to maintain status

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S-Corp vs LLC

Now that you have a better understanding of what an S-corp is, it might be helpful to compare it to another popular business entity, the limited liability company (LLC). But before we jump into the comparison, here’s a brief explanation of what an LLC is.

What is an LLC?

LLCs protect you, as the business owner, from being held personally liable for the actions of your business (or the LLC).  If there is a lawsuit against your business, the LLC protects you from the personal risks.  This means that your personal assets stay safe. Additionally, LLCs have other benefits.

  • LLCs offer pass-through taxation, meaning that taxes are not paid at the business level.  When you create an LLC, income and losses are reported to the IRS on your personal income tax return.  When taxes are due, they are paid on the individual level.
  • LLCs provide flexible management structures, allowing you to take control of daily operations and long-term growth strategies.
  • LLCs face fewer compliance requirements than corporations, as well as fewer state-imposed annual requirements and ongoing formalities.

S-corp and LLC: Compare and Contrast

LLCs and S corps are both are pass-through entities. This means they don’t pay corporate taxes, and both offer limited liability protection for their owners/principals. As a result, business creditors can’t touch the owners’ personal assets. They also can’t be held personally responsible in lawsuits filed against the company.

However, LLCs are more flexible than S corps. This because they aren’t subject to the IRS’s heavy scrutiny and regulations  concerning the number and type of shareholders/owners. They can allocate their profits and losses in whatever proportions the owners desire.

It’s also also easier for business owners to establish an LLC than an S-corp. This is because sole proprietors or small groups of professionals, like attorneys, doctors, or accountants

When it comes to starting a business, entrepreneurs have a number of different options when it comes to business formation. There are sole proprietorships, general partnerships, LLCs, and corporations.

But out of all the business entities available, corporations are the most dynamic, offering tremendous flexibility and advantages as well as asset protection and limited liability protection It’s also the most secure because it’s considered a ‘person’ with rights under the law. This means that a stockholder (owner or partial owner) is a holder of shares of stock in the corporation and is not in legal danger for the acts of the corporation.

There are several types of structures within this entity, but the two recommended by CPAs and attorneys are an S-corp (for tax purposes) and a C-corporation. In this blog post, we’ll walk you through what an S-corp is and why it’s a smart choice for small business owners.

What is an S-corp?

An S corporation, also referred to as an S subchapter, is a type of corporation that meets specific Internal Revenue Code requirements. If it does, it may pass income (along with other credits, deductions, and losses) directly to shareholders, without having to pay federal corporate taxes. The advantages of electing this type of tax election are far reaching. We will explain these advantages in the next section.

Usually associated with small businesses (100 or fewer shareholders), S corp status effectively gives a business the regular benefits of incorporation while enjoying the tax-exempt privileges of a partnership. In short, an S-corp is a type of tax status that comes with tax benefits.

Advantages

From tax advantages to flexibility, forming an S corp has many benefits. One such benefit is pass-through taxation. This allows owners to avoid the double taxation (or paying twice on corporate income) of C corps making it a popular choice for small business owners.

Both S and C corps allow for limited liability of the owners, officers, and directors but while C corps have no limitations on shareholders, S corps cap the number of shareholders at 75.

These shareholders report income, gains, and losses from the corporation on their individual tax returns, and pay taxes at their ordinary income tax rates. Since the money comes to them free of corporate tax, they avoid double taxation on any income or earnings.

Disadvantages

Because S corporation owners will sometimes disguise salaries as corporate distributions to avoid paying payroll taxes, the Internal Revenue Service (IRS) heavily scrutinizes how S corporations pay their employees. An S corporation must pay reasonable salaries to shareholder-employees for services rendered before any distributions are made.

Additionally, when it comes to making those distributions to stakeholders, the S corp must allocate profits and losses based only on the percentage of ownership or number of shares each individual holds.

If an S corp doesn’t do this—or if it makes any other noncompliance moves —the IRS could terminate its Subchapter S status. This happens rarely, though. Usually, a quick rectification of non-compliance errors can avoid any adverse consequences. 

Finally, there are stricter qualifications that the corporation must meet to elect S corporation status. To qualify for S Corp status, your business:

  • Must be a domestic corporation formed in the U.S.A.
  • Can have no more than 75 shareholders.
  • Only individuals, estates, or certain trusts as shareholders.
  • No non-resident alien shareholders.
  • May only have one class of stock.
  • Must be a small business corporation, financial institutions (i.e. banks, insurance companies, building and loan associations, mutual savings, and loan associations) cannot take advantage of an S corporation election.
  • Must conform to state statutory restrictions, which limit the transfer of shares/ownership of the company.

To be more specific, S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations (501(c)(3)). Partnerships, corporations, and nonresident aliens cannot qualify as eligible shareholders.

Pros

  • Allows for limited liability of the owners/officers/directors
  • Typically runs on a calendar year
  • Full disclosure of corporate owners
  • Pass-through taxation

Cons

  • Limited number of shareholders
  • Shareholder restrictions
  • Stricter criteria
  • Potentially growth-inhibiting qualifications to maintain status

S-Corp vs LLC

Now that you have a better understanding of what an S-corp is, it might be helpful to compare it to another popular business entity, the limited liability company (LLC). But before we jump into the comparison, here’s a brief explanation of what an LLC is.

What is an LLC?

An LLC protects you, as the business owner, from being held personally liable for the actions of your business (or the LLC).  If there is a lawsuit against your business, the LLC protects you from the personal risks.  This means that your personal assets stay safe. Additionally, LLCs have other benefits.

  • Offer pass-through taxation, meaning that taxes are not paid at the business level.
  • Provide flexible management structures, allowing you to take control of daily operations and long-term growth strategies.
  • LLCs face fewer compliance requirements than corporations, as well as fewer state-imposed annual requirements and ongoing formalities.

Compare and Contrast

LLCs and S corps are both are pass-through entities. This means they don’t pay corporate taxes, and both offer limited liability protection for their owners/principals. As a result, an owners’ personal assets can’t be touched by business creditors, nor can they be held personally responsible in lawsuits.

However, LLCs are more flexible than S corps. This because they aren’t subject to the IRS’s heavy scrutiny and regulations and other federal or state rules. They can allocate their profits and losses in whatever proportions the owners desire.

It’s also also easier for people to establish LLCs rather than an S-corps. However, their financing options are more limited—generally, to bank loans, as opposed to equity investors. This can limit their potential for growth.

Starting Your S-Corp

To create an S corporation, you must first form a corporation by filing articles of incorporation with your state. After that, you must then file form 2553 with the IRS.

The form states that IRS will accept the S corp status only if the business meets all the qualifications for the status. You can do all these steps on your own or you can let the experts at Inc Authority form your S-corporation for you!

We’ll form your S-corporation, run a business name check, get your EIN, and make sure you have all the licenses and permits needed to run your business. 

Not to mention we offer a ton of free management and report tools to help make running your business as simple as possible.

Incorporating is the most powerful thing you can do to legitimize your business. And at IncAuthority.com, our setup LLC services are 100% free. Always. So, don’t wait. Form your free LLC today and enjoy the protection due to you and your business under the law.

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