An s-corporation, or s-corp, is similar in form to a corporation (c-corporation). However, s-corps avoid the double taxation that c-corps endure by passing the corporation’s income, credits, losses, and deductions onto its shareholders. The s-corporation’s shareholders then report the income and losses on their personal tax return. The s-corporation entity option offers companies limited liability protection, investment opportunity, and perpetual succession. The classification of s-corp occurs at the federal level by filing with the Internal Revenue Service. However, the actual formation of your corporation takes place at the state level in the same manner as a c-corporation.
There are a number of advantages that the s-corporation structure offers. For starters, s-corps enjoy limited liability protection for all of its shareholders, officers, and employees. Additionally, s-corporations enjoy a form of pass-through taxation, which allows for owners to report losses and profits on their personal tax returns. Thanks to this, s-corps avoid the dreaded double taxation that c-corps must face. Double taxation occurs when income is first taxed as income of the corporation, then taxed a second time as the individual’s dividend income. S-corps must only face the second form of taxation.
In addition to these tax-related benefits, s-corps are only required to file an annual tax return, whereas c-corps are required to file quarterly returns. Thanks to their structure, s-corporations provide ample investment opportunities and can attract investors through the sale of stock. Finally, s-corporations enjoy perpetual succession. So, in the event of the owner leaving or passing away, or any transfer of stock occurs, the business continues on without complication.
While there are not many disadvantages linked to s-corporations, there are a few reasons why the s-corp entity structure may not be the best choice for everyone. Here are a few things to note if you are forming an entity and considering an s-corporation:
- S-corporations may only be formed by US citizens or permanent residents, whereas LLCs and c-corporations do not set legal residence requirements for formation.
- S-corps put restrictions on ownership ability, as the number of shareholders cannot exceed 100.
- S-corps tend to receive higher scrutiny from the IRS, due to their dividend and salary distribution structure. Therefore, making a filing mistake can result in termination of your s-corp status.
- S-corps can end up having higher expenses and formation costs than other entities. Fees differ from state to state, but ongoing costs to maintain good standing and proper filing requirements can be costly.
How to Form an S-Corporation
Interestingly, if you wish to form an s-corporation, the place to start is with a c-corporation. The reason for this is that technically all corporations begin as c-corporations. Once you have successfully formed your c-corporation, you can then file a change of status to switch to an s-corporation. However, there are a few requirements if you wish to do this:
- Your corporation must be domestic.
- Shareholders must be individuals (not partnerships or corporations).
- Your corporation cannot exceed 100 shareholders.
- Your corporation can have only one class of stock.
Next, begin your formation as you would with a corporation. First, select a name for your corporation that meets legal requirements and is unique to your business. Next, file your Articles of Incorporation with the state and issue stock certificates for initial shareholders. Then, apply for any necessary business licenses or permits and an employer identification number. Finally, file Form 2553 (Election by a Small Business Corporation) with the IRS in order to become an S-corporation. This form must be signed by all shareholders and filed within 75 days of forming your corporation.