An S corporation is a pass-through entity for tax purposes. This implies that the income losses and credits aren’t made at the corporate level. Instead, these entities pass business income and losses to the shareholders, who report them on their income tax returns. S corp shareholders can be individual persons (e.g., self-employed), specific trusts and estates, or certain tax-exempt organizations. In this article, you’ll learn how an S Corp is taxed, how to form one, and its benefits compared to other entities.
How Is an S Corp Taxed?
Generally, an S corporation is exempt from federal taxes, but tax may apply on certain capital gains and passive income. Let’s look at how taxation works for S corporations:
The S corp doesn’t pay federal income taxes at the corporate level. Instead, the profits or losses of the S corp are allocated to its shareholders based on their ownership percentage, and these amounts are reported on their federal income tax return.
Shareholders of an S corp report their share of the corporation’s income, deductions, and tax credits on their corporate income tax returns. This is typically done using a schedule k-1, which the S corp provides to each shareholder. The corporation shareholders are accountable for paying taxes on their share of the s corp’s income at their individual tax rates.
Avoiding Double Taxation
Unlike C corporations, which are subject to double taxation, i.e., corporate income tax and individual shareholder dividends tax, S corporations avoid double taxation because income is only taxed at the individual level.
Deductibility of Business Losses
If an S corporation incurs a net loss, shareholders can generally make income loss deductions on their individual tax returns subject to certain limitations and rules that can offset other income.
How to Form an S Corp
To qualify for S corporation status in the U.S., there are several steps you must follow. However, consulting with legal and financial professionals is advisable to ensure compliance with all relevant regulations. Below is a general guide to forming an S corp.
- Choose a business name. Ensure the name complies with your state’s naming requirements. Be sure to check the availability of the chosen name.
- File articles of incorporation. Prepare and file the incorporation report with the secretary of state office where you want to incorporate. Include details such as the corporation’s name, address, purpose, registered agent, and the number of authorized shares.
- Appoint a registered agent. Designate a registered agent who will collect legal documents on behalf of the corporation. The agent must have a physical address in the state of incorporation.
- Hold an organizational meeting. Conduct an initial board of directors meeting to elect officers, draft bylaws outlining your corporation’s internal rules and regulations, and handle other organizational tasks. The bylaws document isn’t usually filed with the state but is essential for internal governance.
- Issue stock certificates. Issue stock certificates to the initial shareholders, documenting their ownership in the company.
- File for an EIN (Employer Identification Number). Obtain an EIN from the Internal Revenue Service (IRS). The unique identifier is used for tax purposes and is necessary for hiring employees and opening a business bank account.
- File Form 2553 with the IRS. To elect S corporation status, file form 2553 with the IRS. You must fill out the form within a specific time frame after incorporation.
- Comply with state and local requirements. Fulfill additional state-specific requirements such as business licenses, permits, and state income tax.
- Open a bank account. Open a business bank account in the corporation’s name using the EIN and other relevant documents.
- Maintain corporate records. Keep thorough and accurate records of corporate activities, including meeting minutes, financial transactions, and any corporate structure changes.
S Corp Status Qualifications
The IRS has set specific qualifications to ensure that only eligible corporations can benefit from favorable taxation. These qualifications are designed to maintain the integrity of S Corps and ensure they fit within the parameters of small to mid-sized businesses.
Before deciding to convert your business, understand and evaluate if your company can meet these requirements:
- It shouldn’t have more than 100 shareholders.
- It must have only one class of stock.
- It must be a domestic corporation, i.e., U.S.-based, without non-resident shareholders.
- It shouldn’t be an ineligible corporation.
- It should have allowable shareholders only.
How Do Owners Get Paid in S Corp?
Shareholders actively involved in the business operations of the S corporation may receive compensation. Here’s how they get paid and pay taxes.
In an S corporation, owners may receive their share of earnings as a salary, providing a consistent source of income. This salary is subject to payroll taxes, i.e., social security and Medicare, and the S corp must withhold and pay these taxes on behalf of the shareholder-employee.
Shareholders may receive distributions of profits from the S corporation. These distributions aren’t subject to income taxes. However, you can’t use distributions to avoid paying taxes entirely. The IRS requires that shareholders-employees receive reasonable compensation for the services they provide to the corporation through a salary.
It’s crucial for S corp business owners to work with tax professionals to ensure that their compensation structure complies with tax regulations. The IRS closely scrutinizes the allocation of salary versus distribution to prevent abuse and ensure that shareholder-employees are paying employment taxes on reasonable compensation.
Benefits of an S Corp
S corp taxation offers several advantages, making it an attractive choice for a small business entity. Here are some of its benefits.
Shareholders enjoy limited liability protection, which means their assets are generally protected from the company’s debts and liabilities.
S corps pass business income loss deductions and credits to shareholders to avoid double taxation. The shareholders report the income tax on their individual tax returns.
S corp can attract investors by issuing different classes of stock, allowing for flexibility in attracting capital.
Owners can receive salary and dividend distributions, potentially leading to tax savings compared to a sole proprietorship or partnership.
Shareholders who work for the company can receive certain tax-deductible benefits such as health insurance and retirement plan contributions.
No Alternative Minimum Tax (AMT)
S corporations aren’t subject to the AMT. This separate tax system can apply to individuals and corporations with certain types of income and deductions.
Downsides of an S Corp
While an S corp offers notable benefits, it also presents significant downsides. The following obstacles can manifest themselves in various aspects of running an S corporation.
Restrictions on Ownership
S corps restricts who can be a shareholder. They can’t have more than 100 shareholders; only certain business entities and individuals are eligible.
Limited Growth Potential
The 100-shareholder limit can hinder the ability to increase capital through the sale of stock, which might be a limitation for companies seeking substantial growth.
While pass-through taxation is a pro, it can also be a con as shareholders need to report their share of their company’s business income on their individual tax returns, potentially leading to complex tax situations.
Risk of Losing S Corp Status
Failing to meet the IRS requirements can result in losing an S corp status, leading to unfavorable tax treatment and potential penalties.
Is an S Corp Taxed on Revenue or Profit?
S corporations aren’t taxed on their revenue. They’re generally taxed on their net business income or profit. The net business income is calculated by subtracting allowable business expenses, deductions, and losses from the total revenue.
This net income flows through to the individual shareholders who report it on their tax returns. The shareholders are taxed based on their individual tax brackets.
What’s the Five-Year Rule for S Corp?
The five-year rule refers to the requirement that a corporation must wait for at least five years after electing S corp status before re-electing it if it wants to revoke its S corp status voluntarily. If a corporation revokes its S corporate status before the end of the five years, it may be subject to inevitable tax consequences. Tax laws and regulations can change. It’s always a good idea to consult a tax professional for the most up-to-date and accurate information.
Differences Between S Corporation and C Corporation
In most cases, S corps and C corps provide similar functions, such as protecting their members’ assets. The main difference lies in their tax treatment.
|IRS recognizes it as a pass-through entity and neither files a corporate tax return nor pays corporate income tax.
|IRS recognizes a C corporation as a separate tax-paying business entity and has to pay corporate taxes.
|S corp must have only one class of stock.
|C corporations can diversify stock options.
|S corporation structure has a limit of 100 shareholders.
|A C corporation has no shareholder limit.
|Shareholders are allowed to deduct business losses from income.
|C corp shareholders can’t deduct business losses from income.
|It has restrictions on who can own shares.
|There are no shareholder restrictions.
|Transfers profits and losses to shareholders through wages and dividends, which shareholders report on their tax returns.
|C corp shareholders file a corporate tax return on their dividends to report entity losses deductions and credits.
Is Income from an S Corp Considered Earned Income?
Income from an S corp is generally not considered earned income. In an S corp, the income is typically passed to the shareholders, who report it on their tax returns. This income is often called “pass-through income” because it passes through the business entity and is taxed at the individual level.
On the other hand, earned income is typically associated with wages, salaries, tips, and other forms of compensation for personal services. Earned income is subject to payroll taxes such as Social Security and Medicare.
In the context of an S corp, shareholders may receive a salary for their services to the corporation, which would be considered earned income. However, any remaining income distributed to shareholders as dividends or through the pass-through mechanism is generally not considered earned income.
However, tax laws can be complex and subject to change. Seek counsel from a tax professional or accountant for distinct advice relating to your situation and the latest tax regulations.
Which Is Better for Taxes, LLC or S Corp?
The choice between forming an LLC (Limited Liability Company) or an S corp for tax purposes depends on numerous factors and the specific circumstances of your business entity. LLC and S corp offer distinct tax advantages and disadvantages, and what’s best for you depends on your business’s unique characteristics and long-term goals. Here are some key considerations to aid you in making an informed decision.
LLC and S corp are taxed as pass-through business entities, ensuring no double taxation. However, S corporations have additional requirements, such as restrictions on the number and type of shareholders, which can limit their suitability for some businesses.
LLC business owners may be subject to paying self-employment taxes on all business profits, while S corps owners can reduce their tax liability. They can do this by taking a fraction of their profit as a salary (subject to payroll taxes) and the remainder as distributions (not subject to payroll taxes). They will end up saving on self-employment tax, unlike the LLC owners.
Ownership and Management
LLCs offer more flexibility in ownership structure and management. There are no restrictions on the number or type of members, and management roles can be structured as desired. On the other hand, S corps has specific restrictions on the number and type of shareholders, which may not be suitable for all businesses.
There are specific eligibility requirements for S corporations, including limitations on the number and type of shareholders and restrictions on the type of entities that can be shareholders. S corp status must also be elected with the IRS, and there are ongoing compliance requirements that the corporation and its shareholders must meet.
As tax laws can be confusing and subject to change, consulting with an accountant or tax professional is advisable. This ensures your S corp complies with all the relevant tax regulations and maximizes the tax benefits available to shareholders, whether individual entities, specific trusts and estates, or tax-exempt organizations.