Most of us have heard the term “S corporation,” and many may know that it’s a somewhat sheltered form of business structure, but beyond that, there are many people who really don’t understand what an S corp is all about. If you’re the sole proprietor of a successful small business, it’s a good idea to understand what this business structure is all about, since it may be the next logical step for your company’s growth.
Sometimes referred to as “C corporation light,” an S corporation has advantages over both C corps and doing business with an unincorporated entity. While there are some more rigid qualifying factors, the S corp structure is very compatible with small business.
Advantages of an S Corporation
Perhaps the biggest potential advantage of an S corp over sole proprietorship or a simple partnership is the limits of legal liability. Company officers, shareholders and employees are all protected from financial or legal obligations of the S corp. That is, their personal status is separate from the corporation, so in the case of bankruptcy, for example, only the corporation’s assets are available for settlement. Creditors cannot come after individuals to settle debts.
S corps are pass-through tax entities. That is, the owners report profit and loss on individual tax returns. Other corporation structures see taxes owing on both corporate income and again on shareholders’ dividend income, but S corps are protected against this double taxation. Also, there’s only a single annual tax filing requirement, versus the quarterly returns C corps must file.
Like other corporations, the S corp is its own legal entity, so it can exist beyond the life of the owner, and an S corp can generate funds through the sale of stock to investors.
Drawbacks of an S Corporation
Along with the tax advantages, there are some potential challenges. Since employees and shareholders could be paid either salaries or dividends – each of which is taxed differently – the IRS keeps closer tabs on an S corporation’s returns. If an S corporation makes mistakes with tax filing, one potential result could be the loss of S corp status.
Forming an S corporation is of course more complex than starting a sole proprietorship, and there are various fees and procedures necessary to gain S corp status. Only U.S. citizens and permanent residents can form S corps, unlike LLC or C corporations, which can have foreign owners. Ownership is also limited to 100 shareholders.
Forming an S Corporation
-Depending on the state of incorporation, you may need to reserve a legal name with the Secretary of State.
-Draft your articles of incorporation and file these with the Secretary of State for the S corp’s state of business.
-Initial shareholders receive stock certificates issued by you as owner of the S Corp. This could be 100% to yourself, or a percentage of ownership for up to 100 shareholders. These shareholders must be individuals, not other corporations. Shares must all belong to the same class of stock.
-Apply for a business license for the S corp, as well as any other registrations or certificates necessary for the S corp’s industry.
-Apply to the IRS for an Employer Identification Number (EIN) online or using Form SS-4.
-Apply for the necessary accounts, such as unemployment and payroll tax accounts, required by the S corp’s state of business.
-File Form 2553 with the IRS within 75 days of forming your corporation.
The process of creating an S corporation first takes you through C corporation status and then you file for subchapter S corp status, if you meet all the requirements needed. Meeting the requirements for an S corp is generally easy for most American small businesses, and there are big opportunities to save money and limit liability. There is some precision necessary, particularly in tax filing, so be sure to get the help you need so that you don’t risk loss of S corporation status.