George runs a Textile Company in Newport Beach. His tax accountant advises him to register his business as an S Corporation as this will help him and his shareholders save a lot of tax. George needs to submit Form 2553 by the IRS deadline to obtain the status of the S Corporation. Despite strict records management, George's company shareholders are happier than ever.
Companies differ in many ways from sole proprietors, partnerships, and LLCs. Some businesses can b popularly referred to as C Corporations which means they are eligible to pay corporate tax and can have as many shareholders as they want. On the other hand, there are some S corporations which subject to a special tax designation and are exempt from paying corporate tax. Here we will learn all about S corporations.
Table of Contents
- What Is A Corporation?
- What is an S corporation?
- Features of an S Corporation
- Eligibility Criteria to obtain the status of S Corporation
- Why should you select the status of the S corporation?
- S Corporation and Its Strict Requirements
- Some important documentation
- How to make your company an S Corporation
- IRS Form 2553
- Tax system under S Corporations
- Benefits of being an S Corporation
- Disadvantages of filing your company as an S Corporation
What Is A Corporation?
A company or a corporation is a legal entity that is incorporated by submitting legal entity establishment documents to the state. It comprises shareholders, directors, and officers. Shareholders own the company's shares, directors are the decision-makers who set policies, and executives run the company daily.
Corporations are subject to several legal requirements and documentation that were not found in other types of businesses. Shareholders generally are not personally liable for the company's liabilities.
What is an S corporation?
S corporation or S-corp is a company that has a unique tax designation that can be available to a particular company or LLC. The scope is named after the sub-chapter of the Internal Revenue Code (sub-chapter "S"), with its most distinctive feature - the so-called "pass-through" control structure.
Features of an S Corporation
- S Corporations are commercial corporations that are incorporated in compliance with the Companies Act of the same state
- It offers the same liability protection, ownership, and administrative benefits as C-Corporation. You also need to comply with company practices and procedures
- It establishes a board of directors, prepares the company's articles of incorporation, holds a general meeting of shareholders, and keeps the minutes of important company meetings
- S Corporation is an abbreviation for "Sub-Chapter S Corporation" or "Small Business Corporation". The Internal Revenue Service (IRS) has granted a special tax status to these corporations which allows them to pass on their income, credits, and deductions to shareholders
- Normally, S companies come under the "pass-through entity" and they do not pay federal income tax. The income or loss generated by these corporations is passed on distributed to the company's shareholders and reported in Schedule K1. This is attributed to the shareholders’ income tax return
- Under normal circumstances, a corporation is required to pay both the taxes – personal income tax and corporate tax, but this is the benefit that S corporation enjoys. There is no double taxation and a "tax rate" is applied when the employer's income level falls within the tax range
- S Corporation is not a type of company but is simply a tax designation. Companies cannot apply to be incorporated as an S corporation, but they simply need to get the status through the IRS
- S corporations must report their income on Form the 1120S to the IRS
Eligibility Criteria to obtain the status of S Corporation
The corporation must meet the following requirements to be termed as an S Corporation:
- The corporation should be a domestic company
- Should have not more than 100 shareholders
- The eligible shareholders are individuals, specific trusts, and real estate. They should not be any form of a partnership, legal entity, or non-resident foreign shareholder
- It should have only one class or category of shares of stock
- Must not come under the ineligible corporation entity in terms of being an insurance company, specific financial institution, or a domestic international distributor
- To become an S corporation, it must submit a Form 2553 ‘Election by a Small Business Corporation’ that is duly signed by all shareholders
Why should you select the status of the S corporation?
Running as an S-Corporation makes sense for several reasons:
- When you establish an S corporation, you can usually include a business loss in your income tax return. You can use this to offset income from other sources of income
- When selling an S corporation, the taxable profit from the sale of the business may be less than when operating the business as a normal corporation
- Shareholders of S corporations don’t have to pay the self-employment tax on distributions received. These taxes make up more than 15% of your annual income and are used to pay social security and Medicare taxes. However, shareholders of S corporations usually work as employees of the company, and the payroll tax is levied on the compensation of employees
- Because S-Corporation is a pass-through entity, its shareholders may be subject to a pass-through tax deduction as stated under the Tax Cuts and Jobs Act. Between 2018 and 2025, S Corporation shareholders have the right to deduct up to 20% of S Corporation's income but it has many restrictions. For some income groups, the limit observed cannot exceed 50% of the W2 wage paid by the company. S corporation heads work as corporate employees, and this can give them the benefit of deductions
S Corporation and Its Strict Requirements
Some certain important rules and restrictions need to be followed in S Corporations, which are:
- Each shareholder of S Corporation must be a US citizen or resident
- The profit and loss of S corporation can only be distributed in proportion to the interest of each shareholder to the corporation
- Shareholders of S Corporation may not subtract the corporate losses that exceed the “base” of the company's shares. This is the amount adjusted or deducted from the shareholder's investment in the company
- Under S Corporation, the employee shareholders who have more than 2% of the ownership of the corporation, cannot be eligible to pay for the cost of fringe profits
The entity of being an S Corporation is not permanent. If in the later years, you realize that your company is more profitable and has tax benefits to being a regular legal entity, you can abandon your S Corporation legal entity status after some time.
Some important documentation
1. If your company is an S Corporation, you must follow the requirements of Chart-1:
- You will be liable to use the Form 1120S of Income Tax under Schedule K-1
- The Estimated Tax needs to be filled out using Form 1120-W
- Employment taxes specified under Federal unemployment (FUTA) tax (Form 940), Employers Annual Federal Tax Return for Agricultural Employees (Form 943), Employers QUARTERLY Federal Tax Return (Form 941), Social security and Medicare taxes and income tax withholding, and Excise Taxes
2. For the shareholders of S Corporation under Chart-2:
- As a shareholder, you must file the Income Tax under Form 1040 or 1040SR and Other Forms Referenced in Schedule K1 of Shareholder Instructions on Schedule E and Schedule E (Forms 1040 and 1040SR) along with additional Income and Loss
- Estimated Tax 1040ES
How to make your company an S Corporation
Step 1: Become a C Corporation or an LLC first
To select the status of the S Corporation, you must first be configured as C-Corporation. C-Corporation is simply a regular company and if you meet the limited liability company criteria and meet the IRS standard of S Corporation status, you can choose the status of is beneficial taxation.
Step 2: Check Your Eligibility Criteria
Make sure that your C Corporation meets the requirements of the status of the S Corporation as specified under the Internal Revenue Code (as discussed above).
Step 3: Submit the IRS Form 2553
Once you have verified that your company meets all the requirements of the IRS, you must submit a Form 2553, a small business election signed by all shareholders of the company. You must know how to fill out the 2553 form to simplify the selection process for S corporations.
IRS Form 2553
Step 1 - To establish an S corporation, you must first establish a formal name and book it if your state Secretary of State allows (not all)
Step 2. Prepare the articles of incorporation and submit them to the state secretary
Step 3. Issuance of share certificates to former shareholders
Step 4. Apply for industry-specific certificates and a business license
Step 5. Fill out Form SS-4 or apply for an Employer Identification Number (EIN) online at the Internal Revenue Service website
Step 6. Apply for any other ID number required by your state or local government. Requirements vary from one location to another, but in general, businesses have to pay disability, unemployment, and other payroll taxes. In addition to EIN, you will need the taxpayer number for these accounts
Step 7. Submit the IRS Form 2553 within 75 days of establishing the corporation
Tax system under S Corporations
The IRS describes the scope of an S corporation company that is exempt from federal corporate tax. Profits or income earned from dividends is taxed at the individual level, according to the relevant marginal tax rate which currently ranges from 10% to 37%. It also means that shareholders who meet certain criteria can offset their corporate losses against income from other sources with a return on personal income.
Comparing this status to C corporations, shareholders cannot cancel a company's losses to offset other income in an individual's income statement. They go through "double taxation" and have historically been regarded as the price paid for the benefit of a limited liability company.
US Income Tax Return for S Corporation must be reported to the federal government and a tax return should be filed by filling the Form 1120S. Form the 1120S is often accompanied by Schedule K-1, which reports the dividends, earnings, losses, and other distributions that the company has transferred to the shareholders and describes the ratio of the company's shares owned by each shareholder.
Unlike C Corporations, which must be submitted quarterly, S Corporations, like individual taxpayers, submit only once a year. You must submit Form the 1120S within 15 days, of the third month which is generally March 15th for companies in the financial year. Like individuals, S Corporation can apply for a 6-month extension to file a tax return. To do so, you must submit a request for an automatic extension of the filing deadline for certain income taxes, information, and other corporate tax returns by the normal filing deadline.
Benefits of being an S Corporation
S Corporations provides dual benefits to SMEs – benefits enjoyed by a corporation and the tax benefits of a partnership. Legal claims against business creditors and legal entities do not allow access to the owner's assets, which clearly states that S Corporation provides limited liability protection for the corporate structure.
But like partnerships, S Corporations don't pay corporate tax on the profits and income they generate. Shareholders have the leverage to avoid self-employed taxes if compensation is configured as salary or stock dividends.
Advantages of S corporations
- The big advantage of registering as an S corporation is the tax system advantage. You don't have to pay federal corporate tax. This is highly lucrative especially if your business is a start-up
- S Corporation status reduces the employer's income tax. Owners of S corporations often reduce their self-employed tax obligations by characterizing their earnings as salaries or dividends
- Shareholders of the S corp are treated as employees of the company and are eligible to receive salaries and tax-exempt company dividends if the distribution does not exceed the stock base. If dividends exceed the shareholder's stock base, the excess will be taxed as capital gains, which will be taxed at a lower rate than recurring profit
- Other benefits include the ability to transfer shares and adjust the asset base without complying with adverse tax effects or complex accounting regulations
- Finally, the status of S Corporation helps build trust, credibility, and reliability with stakeholders
Disadvantages of filing your company as an S Corporation:
- The IRS is strictly investigating how S corporations pay employees because S corporations can disguise salaries as company payments to avoid payroll tax payments
- Regarding distribution to these shareholders, S Corporation must allocate profits and losses strictly based on the ownership ratio or the number of shares held by each individual. This rarely happens if S-Corp cannot do this, or if S-Corp performs other non-compliant procedures
- Submissions based on S corporations require time and money. The legal entity must pay other fees related to the incorporation. In many states, owners pay year-end fees, franchise taxes, and other miscellaneous expenses. However, fees are usually cheap and can be deducted as a project cost
- Finally, there are strict eligibility requirements. Limiting the number and type of shareholders can be a burden for fast-growing companies looking to attract venture capital and institutional investors
Before getting your business incorporated under S Corporation you must get all the details related to the eligibility requirements and see how they fit into the business details. Of all the possible corporate structures and tax treatments, S Corporation is a viable option that has specific tax considerations for shareholders.
As many businesses grow, they evolve from one corporate structure to the next. Adhering to the strict regulations as prescribed by S Corporation requirements, you can enjoy the dual tax benefit - They offer the tax benefits of partnerships while providing limited liability protection for the enterprise.
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- An S corporation, also known as an S subchapter, refers to a kind of legitimate entity that gives companies with 100 or fewer shareholders the benefit of incorporation while being taxed as a partnership
- S corporation is not a type of Corporation but just a different set of rules and tax designation allotted to a company
- Corporate income tax filed under S Corporations may pass on business income, losses, deductions, and credits to shareholders
- Shareholders report profit or loss on their tax returns and pay taxes at normal tax rates
- C Corporations can gain the status of S Corporations by filling Form 2553 with the IRS
- The Status of S Corporation is not permanent