What Is An S Corp

What is an S Corp - Word cloud of business terms.

In our study of the prevalent business structures for small business owners, we’ve reviewed sole proprietorships and limited liability companies. Today we answer the question, what is an S Corp?

An S Corp is a special tax designation for small businesses. It allows corporations that meet S Corp requirements to pass-through income, losses, credits, and deductions to its shareholders, thus avoiding double taxation.

That is a concise S corp definition. Below I’ll discuss in greater detail what is an S Corp.

What is an S Corp

An S Corporation is a special small business corporation designation that the company has elected to be taxed under as defined under Subchapter S of the Internal Revenue Code. The Internal Revenue Service defines an S corporation as follows:

“S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.” – IRS: S Corporation

Note: I am a small business owner who writes on business-related topics. Such topics often include legal elements. The information here is not legal advice. Utilize the topics here in preparation for your discussion with your legal counsel.

Is an S Corp a Business Entity

S Corp is a tax designation available to corporations. Corporations are already business entities unto themselves.

How to start an S Corp

Before filing with your states Secretary of State to form your business, I highly recommend you consult with an attorney and accountant to ensure it is the right business structure for you. Below I’ll help prepare you for those conversations.

You do not create an S Corp directly. You first create a Business Corporation by submitting your Articles of Incorporation with your state’s Secretary of State.

Your accountant and attorney will advise you as to the best business structure for you. Your attorney may also offer to file the necessary paperwork on your behalf.

After forming your company with your Secretary of State, you are ready to make your election for S Corp designation with the Internal Revenue Service (IRS).

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Cost to set up an S Corp

Articles of Incorporation: An S Corp is a corporation. It is creation begins with its Articles of Incorporation. The Articles of Incorporation is a legal document, and as such, I recommend that you consult your attorney in crafting this document. The cost of drawing up this document will vary per attorney.

State Filing: An S Corp is a corporation. It is created by filing your Articles of Incorporation with your state’s Secretary of State. The cost for this filing is currently $125 in North Carolina. The cost varies state by state. You will want to visit your state’s Secretary of State’s website for their current filing fee.

Federal Filing: Federal filings include submitting Form 2553. There is no filing fee for submitting this form to the IRS.

Franchise Tax: Corporations are assessed a franchise tax by the state. The franchise tax rate in North Carolina effective for tax years beginning on or after January 1, 2019, the franchise tax rate for S corporations is two hundred dollars ($200) for the first one million dollars ($1,000,000) of the corporation’s tax base and one dollar and fifty cents ($1.50) per one thousand dollars ($1,000) of its tax base that exceeds one million dollars ($1,000,000) and is applied as set forth in the law.

Miscellaneous State filings: Each business may be subject to business or priviledge licenses, fees, and other assessments required by their state or jurisdiction.

Attorney fees: Although you may create and file your S Corp without an attorney, it is not recommended. The fee assessed by your attorney typically depends on the complexity of your organization and the amount of handholding your wish your attorney to provide.

Who owns an S Corp

An S Corp is owned by its shareholders. When electing S Corp tax designation, the underlying business entity must meet particular ownership requirements: 

  • Have only allowable shareholders
  • May be individuals, certain trusts, and estates and
  • May not be partnerships, corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock

” – IRS: S Corporation

Failure to meet the ownership requirements will lead to the S Corp designation to be invalidated. 

An LLC electing to be taxed as an S Corp should review its articles of organization and operating agreement to agree with the S Corp requirements. The business entity remains intact, but should not violate the requirements of an S Corporation.

How is an S Corp Taxed

S Corp taxation is one of the major advantages of its designation. S Corps are tax entities allowing the business to pass-through its income, losses, credits, and deductions to its shareholders. As such, these proceeds are not taxed at the corporate level and avoid the “double taxation” that C Corps are subject to.

S corporations are responsible for tax on certain built-in gains and passive income at the entity level. 

S Corp tax rate

As a tax entity, S Corps revenues are untaxed at the corporate level. Instead, the business income, losses, credits, and deductions are passed through to the shareholders. It is then taxed at the shareholder’s individual tax rate.

How frequently is an S Corp Taxed

An S Corp avoids the quarterly tax requirements of a C Corp. Instead, the S Corp passes through its income, losses, credits, and deductions to its shareholders. The shareholders, in turn, file their individual taxes annually. Depending on an individual’s tax situation, quarterly estimations and other considerations may be required.

How are S Corp owners Compensated

An S Corps owners are its shareholders. Owners who actively work in the business are also employees and are paid a salary. All employees are subject to employment tax. Shareholders may also benefit from a distribution of the companies profits. 

What is a S Corp - Top view of mobile phone,pen and calculator on wooden background written with S Corp. Business and finance concept.

S Corp Liability Protection

An S Corp is a corporation. Its shareholders have limited liability from business financial obligations, losses, and liabilities. If the company is unable to meet its financial obligations, its creditors are limited to the assets of the business. The shareholder’s liability extends only to the amount of their investment in the company.

Investment Opportunities

An S Corp is a corporation with a maximum stock allocation of 100 shares. All shares must be of the same class. Shares allow investing in an S Corp to be a simpler process. Shareholders can freely sell their interest in a company at their sole discretion.

Perpetual Existence

An S Corp is a corporation. It is an entity unto itself which is owned by its shareholders. The operation of the business is not dependent upon an owner of shares unless the shareholder is also an employee. If the employee leaves the company or passes away, the company can replace the employee and continue operation into perpetuity. The buying or selling of shares does not directly impact the existence of the corporation.

Requirements for the ongoing existence

Corporations have strict requirements to maintain their business status. Such requirements include:

  • State registration
  • Licensing
  • Board meetings
  • Meeting minutes
  • Taxes
  • Securities
  • Bookkeeping

Advantages & Disadvantages

An S Corp enjoys certain advantages over a C-corp as long as the business meets certain requirements.

S Corp Advantages

Avoids double taxation: C Corps are taxed both at the corporate level and the profits are taxed again at the shareholder level. S Corps are not taxed at the corporate level. Instead, the S Corp enjoys pass-through taxation and is profits, losses, credits, and deductions are applied and taxed once.

20% Qualified business deduction: The Tax Cuts and Jobs Act of 2017 gave eligible S corp shareholders a deduction of up to 20% of net “qualified business income”.

S Corp Disadvantages

Limited number of shares: S Corps are limited to a maximum share volume of 100 shares.

Limited share classification: S Corps are limited to only a single share classification. They cannot employ preferred stock vs common stock.

Limitation of ownership: Ownership of an S Corp is limited to individuals, certain trusts, and estates and may not be partnerships, corporations or non-resident alien shareholders.

Note: This article is written based on the definitions established here in the United States of America. Similar business structures exist worldwide. Definitions are different and nuanced based on the jurisdiction in which you reside.

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