Your Essential Guide to S Corporations

Accounting
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Fincent Team

Starting a business requires you to be thorough with the concerned laws and taxation requirements. As a business owner, you would want to keep your personal assets separate from your business entity. An S corporation helps you do just that.

As a tax status assigned to over 5 million businesses globally, S corporations offer various tax benefits and other perks. In this guide, we'll walk you through the different aspects of an S corporation.

What Is an S Corporation?

An S corporation is usually a corporation that has an appointed "S corporation" tax status. The special designation is granted by the IRS and comes under the Subchapter S of Chapter 1 of the Internal Revenue Code (IRC).

An S corporation can pass its corporate income, losses, deductions through to its shareholders. Thereby, businesses with the S corporation status can avoid double taxation.

The shareholders in an S corp are also safeguarded against personal liability. In simple terms, it means that they are not responsible for any debts accumulated by the business. The investors are not accountable to pay out of pocket if the business goes belly up.

To reiterate, an S corporation is more of a tax status than a type of business entity. You will need to incorporate as a standard C corporation or an LLC, after which you can apply as an S corp.

How Is an S Corporation Different From a Limited Liability Company (LLC)?

S corporations and LLCs are both preferred by small business owners. The key is knowing where your business interest lies and suits it the best.

Both LLC and S corps share mutual features. They are both separate legal entities, and the shareholders in both enjoy no personal liability to the business.

Among other similarities, both of them also differ in various ways.

Requirements for Becoming an S Corporation

Now that you have decided to get the S corporation tax status, let's break down the requirements you need to fulfill for it.

Step 1: Establish an LLC or a C Corporation

Since an S corp is not a legal business entity in itself, you will need to incorporate it as one beforehand. For this, you must file your business with your state or territory.

But before you move forward, it's best to check with an attorney or a CPA to better understand the implication of choosing a business type.

Step 2: Ensure Your Business Qualifies for the S Corp Status

The IRS grants the S corp status under a few terms and conditions. Make sure your company fulfills the eligibility requirements listed here:

  • Your business needs to be based and functioning in the United States.
  • It must not be a financial company, insurance, or a domestic international sales corporation.
  • The company needs to issue only one class of stock.
  • It can only have allowable shareholders - individuals, certain trusts, and estates. Corporations, partnerships, and non-resident citizens can not be shareholders.
  • The total shareholder count must not exceed 100 shareholders.

Step 3: File Form 2553

Once you have checked off everything from the eligibility checklist, you can now file Form 2553 signed by all the shareholders of your company. LLCs will need to file Form 8832. Your business can expect to hear back from the IRS within 60 days of filing the form.

Advantages of Becoming an S Corporation

By now, you know that S corporations are afforded many advantages over sole proprietorships and partnerships. The S corp structure is particularly handy when you need to transfer the ownership of your business or cease operations.

Here’s a look at some of the advantages of an S corporation:

Limited Liability

An S corporation is a legal entity in itself, unlike a sole proprietorship where the owner and the business are considered the same. This means that creditors cannot pursue the personal assets of a shareholder to settle debts taken on by the S corporation. This limited liability makes this type of structure quite attractive to business owners.

Ease of Transfer of Ownership

S corporations make it easy to transfer ownership without the caveat of potentially terminating the business, as is possible with LLCs and general partnerships. You can also change ownership without attracting heavy taxation consequences.

Easy Cash Method of Accounting

Larger corporations must use the accrual method of accounting. But unless the business has inventory, S corporations can stick to cash basis accounting. This makes the accounting process a whole lot simpler.

Disadvantages of Becoming an S Corporation

While there are several upsides to S corporations like the ones listed above, you should consider the downsides as well to decide if it’s the right business structure for you.

Costs of Formation and Other Expenses

To set up an S corporation, you’ll need to incorporate the company. This involves filing your Articles of Incorporation in the state you wish to have your S corporation incorporated. You need to pay a fee to the registered agent at this stage.

Apart from the initial cost, your state jurisdiction might require you to pay ongoing fees for annual reports. These fees are not exorbitant, but it’s important to understand that sole proprietorships don’t attract these fees.

Restrictions of Owning Stock

S corporations can only issue stocks of one class, though they can be either voting or non-voting shares. Besides, foreign individuals cannot invest in S corps, and the maximum number of shareholders in the company is capped at 100.

Scrutiny by Authorities

The authorities - and specifically the IRS - scrutinizes S corporations more than they would sole proprietorships. Shareholders are either paid a salary or dividends, and the IRS is always on the lookout to make sure that payments are characterized correctly. This is because salaries attract employment taxation laws while dividends do not.

Are S Corporations Taxed Equally Across States?

This is not necessarily true and may depend on your state’s jurisdiction. Generally, S corporations do not attract corporate-level federal taxes.

Some states might treat S corporations the same way as C corporations for state taxes, helping you save taxes only at the federal level. A tax advisor can help you ensure your state’s stance on taxing S corporations.

That said, you can consider setting your business up as an S corporation for benefits such as flexibility in the characterization of income. For a small business, it can be quite favorable from a taxation perspective.

In Closing

Overall, S corporations are more tax-favorable than other business structures like C corporations, sole proprietorships, or general partnerships. Regardless, you should weigh the pros of an S corp against the cons to know if it is suitable for your unique business requirements.

For any help with small business accounting, consult a professional bookkeeping service like Fincent. Let us take care of your books, so you're free to do what you do best: create.

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