An S corp is defined as a corporation that elects to be regarded as a pass-through organization for federal tax purposes. The sort of business, the strategies for the business, and the owners’ short- and long-term goals all play a role in determining whether you should become an S corporation (S corp).
We believe there isn’t a “one size fits all” type of corporation. Our goal is to help you understand the benefits and drawbacks of an S corp so that you can decide if this is the proper business organization for you.
What is an S corp?
An S corp is a pass-through organization, also known as a flow-through entity. This is a corporate structure where the profits of the business are recognized as the owners’ personal income. It’s designed to prevent double taxation, which can happen when a company’s earnings are paid to corporation tax first, then to the owner’s individual income.
S corps are taxed under the Internal Revenue Code’s (IRC) Subchapter S, which is where their name comes from (Subchapter S Corporation). What exactly does that imply?
An S corp is formed by submitting Articles of Incorporation to the Secretary of State or another government agency. It has shares and is governed like a corporation, with the same directors, officials, and shareholders as its C corporation (C corp) counterparts.
The owners (stockholders) of an S corp are protected from responsibility in the same way that shareholders in a C corp are. Personal assets of S corp shareholders, such as personal funds, cannot be confiscated to satisfy business debts.
How to become an S corp
Not just any company can become an S corp. In order to qualify, your business must meet the following standards:
- Shareholders must be people, certain trusts, estates, and specific exempt organizations (ei: 501(c)(3) nonprofit). They can’t be partnerships or corporations.
- Shareholders must be US citizens or residents.
- Must have less than 100 shareholders per business
- A business can have just one class of stock.
- The business profits and losses may only be given fractionally to each owner’s interest in the company.
- The business can’t be an “ineligible corporation” according to subchapter L, domestic international sales corporation (DISC), or possession corporation under section 585.
- All shareholders must consent to the election.
After filing your Articles of Incorporation, you must file Form 2553 with the IRS to elect S corp status for your business. Your S corp also needs to hold an inaugural meeting (first meeting of directors) during which bylaws and other initial corporate activities must be adopted (such as appointing officers and selecting a way to open a business bank account).
Stock certificates should be distributed to shareholders, and these activities should be recorded in the company’s stock transfer ledger. The acts of the executive meeting should be recorded and stored in a corporate record book alongside the Articles of Incorporation and bylaws.
Consult an attorney or accountant if you have specific questions about which business form is best for your case.
Benefits of becoming an S corp
Profits made as an S corp, as well as many tax deductions, credits, and losses, are transferred through to the owners instead of being taxed at the corporate level. This eliminates the risk of “double taxation”, meaning owners do not have to pay taxes twice: first at the corporate level and again at the level of individual shareholders.
On the gains and losses passed over to every shareholder, which are reported as net income on the income tax return, each shareholder is subject to his or her tax rate.
As of 2019, an S corp can contribute up to 25% of an employee’s compensation, or $56,000 (whichever is less), to a Simplified Employee Pension Individual Retirement Arrangement (SEP IRA). SEP IRA contributions must be made on or before the due date of the employee’s tax return.
An S corp with no additional employees, owned by a single person or a married couple, can set up a Solo 401(k) plan and defer up to $19,000 in income (per individual) from taxes as of 2019. The amount of a Solo 401(k) contribution made by an employee will diminish the employer’s SEP IRA contribution limit.
One of the biggest benefits of an S corp is that, regardless of its tax status, it offers limited liability protection to its owners. Limited liability protection protects the owners’ personal assets from business creditors’ claims, whether the claims are based on contracts or litigation.
Employee expense deduction under an accountable plan
Workers can no longer subtract out-of-pocket business expenses from their personal tax returns under current tax laws. As a result, the only way for employees to avoid paying out of pocket is for the company to compensate them.
Out-of-pocket business costs for an S corp can be paid by the employee and repaid by the S corp. Rent for a home office, car mileage or transportation fees, cell phone and internet contracts, and other expenses are examples.
Main advantages of S corp vs C corp
- No double taxation – S corps don’t pay corporate income tax. They divide income and report it on a personal tax return.
- Deductions – Most S corps can deduct 20% of business income on their return.
- Ability to write off business losses on their tax return- This is a benefit for new businesses operating at a loss for their initial years.
If you’re seeking a business structure that combines the benefits of a corporation with the benefits of pass-through taxation, an S corp may be the best option. However, some criteria must be met to make the election. Business owners should also weigh the benefits of incorporating their business against the lack of flexibility and more elaborate formalities enforced on a corporation as opposed to an LLC.
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