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What Is an S-Corp? Tax Benefits and Limitations

What Is an S-Corp? Tax Benefits and Limitations

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Key Takeaways

1.  S Corporations or S Corps combine the legal benefits of a corporation with the tax advantages of a partnership.  

2. S Corps are pass-through entities and therefore avoid double taxation by passing income, losses, deductions, and credits directly to their shareholders. 

3. S Corps do not pay federal corporate income tax, instead shareholders report income on their personal tax returns.

4. S Corp allows shareholders to be classed employees, meaning they can designate income as salary or dividends. This flexibility and ability to distribute tax-free dividends allows some shareholders to realize savings on self-employment taxes.

Are you operating as a corporation of Limited Liability Company (LLC) in the US and looking for the optimal tax status? S-corporations (S-corp) is a way of registering your corporation or company in the US so as to pass through income to shareholders. 

Read on to find out whether you are eligible for S-corp status. 

What is an S Corp?

In the USA, an S Corporation or ‘S Corp’ is a unique business structure that combines the legal benefits of a corporation with the tax advantages of a partnership. S Corps take their name from Subchapter S of the Internal Revenue Code, which covers the tax treatment of S Corporations and their shareholders. Businesses that meet the requirements set out in the IRS’s code can opt for S Corps status and avoid paying federal corporate income taxes.

For small businesses with growing revenues, the tax benefits of S Corp status is perhaps the biggest benefit. Whereas traditional corporations, known as C Corps, pay corporate income tax at the entity level; S Corps are classed as ‘pass-through entities’ meaning profits, losses, and deductions pass through to shareholders directly, thus avoiding double taxation.

Aside from their tax treatment and limited liability protection for shareholders, S Corps offer a number of other benefits, including increased credibility and stability as well as flexibility around transferring ownership. We will cover these benefits in detail later on in this article, but first we will look at the requirements for qualifying as an S Corp. 

What are the IRS Requirements for S Corp Classification?

Only certain businesses qualify for S Corp status. The requirements are set out in Subchapter S of the Internal Revenue Code. To qualify for S Corp status, businesses must:

  1. Be a domestic corporation
  2. Have only allowable shareholders. This means individuals, estates, permitted trusts and certain types of tax-exempt organizations. No partnerships, corporations or non-resident alien shareholders are allowed
  3. Have no more than 100 shareholders
  4. Have only one class of common stock
  5. Be an eligible corporation. Certain financial institutions, insurance companies, and domestic international sales corporations are ineligible.

Once qualifying as an S Corp, the business must maintain compliance with these requirements, or risk losing its S Corp status. For example, businesses that surpass 100 shareholders will lose their S Corp status.

S Corps vs C Corps vs LLCs

To further understand this form of business entity, it’s helpful to understand the similarities and differences between S Corps and C Corps & LLCs. 

All three of these business arrangements separate the company’s assets from its owners, but each offers different pros and cons.

1. S Corps vs. C Corps

C Corp status is the most common tax structure for corporations in the United States. C Corps pay corporate income taxes at the federal level and then shareholders pay personal income tax on any capital gains realized from dividends. S Corps do not pay corporate income tax at the federal level, instead any business income, deductions, and losses ‘pass through’ to shareholders. 

2. S Corps vs. LLCs

Of the various forms of legal business entities in the USA, S Corps share the most similarities with Limited Liability Companies (LLCs). This is mainly due to the tax treatment, where both S Corps and LLCs are classed as ‘pass through’ entities. In fact, eligible LLCs can easily convert to an S Corp by re-registering as a corporation and then filing articles of incorporation for a corporation with their state authorities. 

Note, S-Corp status requires adherence to more rigid operational formalities than being an LLC, such as having a board of directors and holding regular meetings. 

Generally, LLCs are more suitable to smaller businesses with a few partners, such as professional services consultants, law firms, and private dental practices. If they reach a certain size, they may decide to convert their LLC to an S Corp.

Reasons to Establish an S Corp

S Corps offer various benefits and establishing this form of legal entity makes good sense for certain businesses. However, in general there are 3 key benefits of establishing an S Corp in the USA.  

1. IRS Tax Treatment

S Corporations are classed as pass through entities for federal tax purposes. This tax position avoids double taxation as the S Corp’s income passes through to its shareholders, who pay tax on their personal share of the income.

2. Personal Tax Flexibility 

S Corps allow shareholders to be company employees and classify income as both salary and dividends. 

This means that S-corp shareholders effectively only pay self-employment tax on the salary component of income, while income received from company dividends isn’t subject to self-employment taxes.

3. Limited Liability Protection

As with C Corps and LLCs, S Corps separate and protect their shareholders’ personal assets from the business’s debts.

How to Incorporate an S Corp

The process for setting up an S Corp is similar across much of the United States. The first step is incorporating a C Corporation in the state you intend to form the new entity. It’s then a case of electing to become an S Corporation by filing form 2553 with the IRS. 

In step order, the process for establishing an S Corp looks like this: 

  1. File Articles of Incorporation with your state to create a C Corp;
  2. File Form 2553 to the IRS to elect S Corp status;
  3. Comply with legal and governance requirements by holding an initial meeting of directors, and keep official meeting minutes;
  4. Issue shares of stock to shareholders;
  5. Obtain any necessary licenses & permits at local, state, and federal levels;
  6. Maintain compliance with IRS filing and financial reporting requirements.

Of course, the exact process may vary slightly from state to state. Wherever you decide to incorporate, careful attention must be paid to the subsequent management to ensure compliance with IRS filing and governance requirements.

For more information on whether your business is eligible for tax S-Corp status, get in touch with our US compliance experts. 

Frequently Asked Questions

The main tax benefit S Corps have over C Corps is the avoidance of double taxation. In a C Corp, profits are taxed at the corporate level and again at the individual level when distributed as dividends to shareholders. S Corps are classed as ‘pass through’ entities, meaning that profits, losses, deductions, and credits pass directly to shareholders' personal tax returns, thereby avoiding corporate federal taxes. These tax savings are attractive, particularly for small growing businesses.

Yes, eligible LLCs can be converted into S Corps. The process involves first re-registering the LLC as a corporation with the state. After this, the business must file Form 2553 with the IRS to elect S Corp status.

 

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