What is an S Corporation?
Choosing the right type of business organization is one of the most important decisions you’ll make professionally. It has long-lasting consequences, and paves the way for your business in a variety of ways, including tax filing, management and operations, and legal status. One of the newer and more popular business types is the S corporation.
S corporations are named after Subchapter S of the Internal Revenue Code. An S corporation is a business that has decided to “pass through” their profit and losses to shareholders for federal tax purposes. That means all income, losses, credits, and deductions are claimed by individual shareholders rather than taxed at the corporate level. The S corporation is desirable because it eliminates the issue of double taxation.
Qualifications to Become an S Corporation
There are rather strict qualifications you have to meet before you can consider electing S corporation status. To start, you must incorporate first as a traditional C corporation. Then you must meet the following requirements as set forth by the IRS:
- Only domestic corporations can be an S corporation — no international or foreign-owned companies
- Shareholders can only be U.S. citizens or residents
- Shareholders can only be individual people, plus some trusts and estates as well — they cannot be other corporations or partnerships
- You are allowed a maximum of 100 shareholders
- Only one class of stock is allowed
- You cannot belong to a corporation that is declared ineligible —insurance companies, domestic international sales corporations, or certain financial institutions
How to File for S Corporation Status
If you meet the qualifications set forth above, you have to file for S Corporation status by completing Form 2553 Election by a Small Business Corporation to the IRS. It must be signed by all shareholders.
Then, you need to make sure you understand what tax forms are required as an S corporation. For example, although federal taxes are paid at the individual shareholder level, S corporations need to file IRS Form 1120S which is primarily for informational purposes so the government knows how much taxes they should be expecting from each person. Shareholder profit, losses, and deductions are noted on Schedule K-1 so everyone knows what numbers to use for their personal returns.
Advantages and Disadvantages
As with any business type, there are advantages and disadvantages. Avoiding double taxation is obviously one of the main advantages. However, not all S corporations can benefit 100% from the double taxation benefit. If you do business in multiple states, be aware of local tax laws. For example, California levies a franchise tax on all S corporations.
Liability protection is another desirable aspect of S corporations. Creditors can make no claim on personal assets of shareholders in hopes of settling business debts. This is different from sole proprietorships and partnerships that are at risk when a business debt arises.
If you don’t follow the rules exactly, you can be labeled noncompliant and the IRS will strip your business of its S corporation status. It’s important to keep detailed records and do all your accounting so you don’t risk losing status.
There are other advantages and disadvantages to S corporation status. However, the decision to elect S corporation status is entirely personal and what works for one small business may not work for another. If you’re contemplating filing an S corporation, it’s important to meet with a skilled Washington DC business attorney who has experience with S corporations. Contact our team at Tobin O’Connor & Ewing to schedule a consultation and let one of our knowledgeable attorneys help you choose the right business organization for your company.