What Is an S-Corp? Everything You Need to Know

If you are an entrepreneur, you may have stumbled upon the term “S-Corp” in your quest for legal entity, financial clarity, and tax efficiency. 

In a world where every penny counts and strategic decisions can make or break your dreams, understanding S-Corporations is more crucial than ever. 

But what does it really mean, and how can it benefit your small business?

That’s why doola’s business formation services begin with a free consultation. Once we understand your business goals, needs, and preferences, we guide you through each step of the process, providing personalized advice along the way. 

In this blog, we’ll discuss S-Corps — business structure, benefits, drawbacks, and everything in between — so you can confidently steer your enterprise toward success!

What Is an S-Corp?

An S-Corp, also known as a Subchapter S Corporation, is a special type of business structure that combines the features of a corporation and a partnership. 

Unlike C-corporations, an S-corporation is not considered a separate entity from its owners for tax purposes. It offers limited liability protection to a corporation with the tax benefits of being treated as a partnership.

This allows it to pass its taxable income, credits, deductions, and losses directly to its shareholders, thus avoiding double taxation.

How Does an S-Corp Work?

Let’s delve into the details of how an S-corp works and functions:

Formation and Election

To form an S-Corp, you must legally register your business with the state as a corporation or C-Corp by filing Articles of Incorporation with the state in which you want to do business. 

Then, you can elect S-Corp status by filing Form 2553 with the IRS, “Election by a Small Business Corporation,” ensuring that it meets the eligibility requirements.

Ownership

Shareholders own S-Corps through the shares they hold.

Since only one class of stock can be issued, all shareholders have equal voting power and profit distribution rights. So, they must elect a board of directors that oversees the company’s operations.

The board can also appoint Chief Operating Officers (CEOs) who manage the company’s day-to-day operations.

Profit Distribution

S-Corps can pass profits directly to shareholders through salaries, distributions, or both.

You can even pay shareholders who are also employees “reasonable” salaries to abide by payroll taxes. 

Unlike C-Corps, where distributions are based on ownership percentage, S-corporations allow for more creative ways of dividing profits among shareholders. 

For example, with an S-Corp structure, profits can be distributed according to each individual’s contribution or role within the business. 

Pass-through Taxation

The most significant advantage of forming an S-corporation is its pass-through taxation, which means it does not pay federal corporate income tax.

So, the profits earned by an S-Corp pass through the company and directly to its shareholders’ personal tax returns,

This means that income taxes are only paid once at the individual level based on each shareholder’s percentage of ownership.

Likewise, S-Corp can also pass through its losses, as shareholders might be able to offset other income from their personal tax returns.

Each shareholder reports their share of the S corp’s income, expenses, losses, deductions, and credits on their tax return. They then pay for this income at their individual income tax rate.

Limited Liability

Shareholders of an S-Corp have limited liability protection, meaning their personal assets generally receive protection from the company’s debts and liabilities.

This means that their assets, such as their home, car, and savings account, are not at risk in case the company faces financial difficulties or legal issues.

So, if your company falls into debt or faces a lawsuit, they can only pursue your business assets — not yours.

Annual Reporting

All corporations are required to file an annual report with their state’s Secretary of State office, which includes such information as business address, registered agent, and shareholder information. 

Additionally, S-corps must also file Form 1120S with the IRS each year along with Schedule K-1 for each shareholder to report their share of profits or losses.

While we have covered nearly everything, each state may have different requirements and regulations for S-Corps.

Consult with a business formation expert to determine whether this structure is suitable for your business needs.

S-Corp vs. C-Corp: What’s the Difference?

One of the main differences between an S-Corp and a C-Corp is their eligibility for taxation under different IRS subchapters. 

As mentioned earlier, an S-Corp can be eligible for pass-through taxation, while C-Corps fall under IRC Subchapter C and are subject to double taxation. 

This means that a C-Corp pays taxes on its profits at the corporate level, and shareholders also pay taxes on any dividends received from those profits as part of their personal income.

Another significant difference between these two structures is in their ownership restrictions. S-Corps can have no more than 100 shareholders (individuals or specific trusts), all of whom must be U.S. citizens or permanent residents. 

On the other hand, C-Corps can have an unlimited number of shareholders and different classes of stock with varying voting rights.

But on the bright side, S-Corps offer greater flexibility in terms of management structure compared to C-corps. 

While a C-Corp has a traditional top-down hierarchy, S-Corps can opt for a more democratic approach where all shareholders have an equal say in how the business is run.

S-Corp Eligibility Requirements

Before deciding to form an S-Corp, you must understand whether or not your business can qualify as an S-Corp.

The first and foremost requirement for being able to elect an S-Corp is that the company must be incorporated in the United States. 

This means that it must be registered and operate within one of the 50 states or the District of Columbia.

To qualify as an S-Corp, your business must meet the following requirements:

✔️ Be a domestic corporation

✔️ Have only allowable shareholders (You can only have individuals, certain trusts, and estates as shareholders)

✔️ Have no more than 100 shareholders

✔️ Have only one class of stock

✔️ Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)

Tax Benefits of an S-Corp

First and foremost, the pass-through taxation of an S-Corp makes it an appealing choice for small business owners since it can result in significant tax savings.

Moreover, an S-Corp allows for certain deductions that are not available to traditional corporations or sole proprietorships. This could reduce taxable income and result in lower overall taxes paid by shareholders.

One such deduction is the ability for shareholders to deduct their share of business expenses on their personal tax returns rather than having them deducted at the corporate level. 

Additionally, as with any business entity, certain operational expenses can be deducted from an S-Corp’s taxable income. 

These deductions include salaries and wages paid to employees (including owners who are actively involved in running the business), advertising costs, rent or mortgage payments for business property, and insurance premiums.

Another potential advantage of becoming an S-Corp is that the company’s losses can be offset against shareholders’ other sources of income. 

However, it is always best to consult with a formation expert before making any decisions about your business structure or taxes.

Potential Drawbacks of an S-Corp

As with any business structure, choosing an S-Corp for your company has potential drawbacks. While these drawbacks are not deal-breakers, you must understand them before deciding to become an S-Corp.

• Strict Eligibility Requirements: The strict eligibility requirements can limit the growth potential for businesses that plan to attract outside investors or international owners.

• Complex Tax Requirements: S-Corps have more complex tax requirements than sole proprietorships or partnerships. This can be time-consuming and costly for small businesses that may not have the resources to hire tax professionals.

• Tedious Ownership Transfer: S-Corps are subject to stricter regulations regarding ownership transfers. Any changes in ownership can result in loss of status as a corporation and potentially lead to higher taxes.

Also, they have to face a gruesome level of scrutiny, which can be burdensome for smaller businesses without a dedicated governance team.

Since S-corps issue stocks to shareholders regulators and require more extensive record-keeping practices compared to other business structures.

So, it’s always best to consult with a legal or formation expert who can guide you through these challenges with ease.

How to Form an S-Corp

Forming an S-Corp, or S corporation, involves several steps to ensure its legality and functionality.

Once you have determined that your business is eligible for S-Corp status, you can follow these steps to incorporate and start operations.

Step 1: Form a C-Corp

The first step in forming an S-Corp is selecting a unique and distinguishable name for your business that complies with your state laws. 

Then, you must prepare and file the Articles of Organization with the Secretary of State’s office in the state where you plan to operate the business. 

This document outlines essential information about your company, such as its name, purpose, structure, and initial directors.

You should also draft an Operating Agreement and bylaws that govern how your corporation will be operated and managed. 

The agreement should include information about share distribution among shareholders, decision-making processes, meeting procedures for directors/shareholders, etc.

Step 2: Elect S-Corp Status

Once you have completed all the above steps, your business is ready to elect S-Corp status with the Internal Revenue Service (IRS). 

To do this, you will need to file Form 2553 with the IRS within 75 days of your corporation’s formation.

You must also apply for a new EIN even if you already have an EIN for your business.

Since your previous EIN was for a C-Corp, you might need to get a new one for your S corp.

Step 3: Comply With Legal Requirements

Once your status is approved, you must stay compliant and fulfill ongoing responsibilities as an S-Corp. 

This includes holding regular meetings, updating corporate records & filings, maintaining proper accounting practices, and adhering to tax obligations.

• Hold annual shareholder and board meetings to follow corporate formalities.

• Keep detailed corporate records of all business transactions, meeting minutes, and shareholder information.

• File an annual income tax return (Form 1120-S) and submit Schedule K-1s for each shareholder, reporting their share of the company’s income, deductions, and credits.

S-Corp Filing Requirements and Deadlines

Firstly, you must file Form 2553 with the Internal Revenue Service (IRS), which allows your business to be treated as an S-Corp for tax purposes. 

It must be filed within two months and 15 days from the date of formation or by March 15th for existing businesses who want to switch to S-Corp status for that tax year.

S-corps are required to file an annual return with both federal and state tax authorities in addition to filing Form 2553 with the IRS. 

This return, which is usually due on March 15th following the close of each calendar year, should detail information such as the company’s income and any distributions made to shareholders.

Furthermore, if an individual shareholder receives income from dividends or salary through their involvement in the company’s day-to-day operations, they are required to submit estimated tax payments throughout the year using Form 1040-ES. 

S-Corp vs. LLC: Which Is Right for You?

As a business owner, choosing the right legal structure for your company is crucial as it affects your taxation, liability protection, and even your ownership structure. 

The 2 most popular options for small businesses are S-Corps and Limited Liability Companies (LLCs). Both offer significant benefits, but it’s essential to understand the differences between them to determine which one is right for your business.

An S-Corp is considered a “pass-through entity,” meaning that profits or losses are passed through to the shareholders’ personal tax returns. 

On the other hand, an LLC can choose how it wants to be taxed — either as a pass-through entity like an S-Corp or as a corporation with its own tax return.

In an LLC, owners are referred to as “members” and have limited liability for any debts incurred by the company. 

However, in an S-Corp, shareholders may still be held personally liable if they guarantee loans or obligations on behalf of the corporation. 

Additionally, members of an LLC have more flexibility in managing their company compared to shareholders in an S-Corp, who must follow certain formalities, such as holding annual meetings and keeping detailed records.

Ultimately, the decision between an S-Corp and an LLC will depend on your individual business needs and goals. 

Consult with our formation experts to determine which one is right for your specific business situation.

Is an S-Corp Right for Your Business?

Ultimately, an S-Corp may be a good fit for small businesses that want the protection of limited liability without being subject to double taxation. 

It can also be beneficial for companies looking to attract investment or have long-term growth plans. 

However, you need the guidance of a formation expert or doola’s Business Formation Services, to ensure your journey from C-Corp to an S-Corp is as smooth as butter.

Form Your S-Corp Without Any Hassle and Stress With doola

If you have finally made up your mind to form an S-Corp, you may feel overwhelmed by the legal requirements and paperwork.

However, with doola’s Formation Services, the process couldn’t be easier.

We take care of all the necessary steps to establish your S-Corp, from preparing and filing all required documents with the state to ensuring compliance with IRS regulations. 

Our experienced team will guide you through every step of the process so you can focus on running your business without any added stress or hassle.

Our team also provides ongoing support after formation to ensure continued compliance with state laws and regulations. 

We can assist in drafting Operating Agreements, prepare stock certificates for initial shareholders’ issuance, and provide a Registered Agent within the state.

We will also help you fulfill your tax obligations as an S-Corp and ensure that you comply with all IRS requirements.

Book a free consultation today to get started on forming your S-Corp business structure.

FAQs about S-Corps

Can foreign investors be shareholders in an S-Corp?

Yes, non-resident aliens can hold shares in an S-Corporation as long as they don’t own more than 25% of the total Shares.

Do I need to pay myself a salary if I am the owner of the company?

As an owner-employee of your own company, you must receive reasonable compensation for services rendered just like any other employee. 

This means paying yourself a fair market salary based on industry standards and your job duties rather than taking distributions from profits.

What types of businesses are eligible to be classified as an S-corporation?

Most businesses can qualify, except for certain financial institutions and insurance companies.

Can I convert my existing C-Corp to an S-Corp?

Yes, it is possible to make the switch from being taxed as a C-Corp to filing taxes as an S-Corp. 

Can I convert my S-corp into another type of business structure in the future?

Yes, it is possible to change your business structure from an S-Corporation to another type, such as a C-Corp or LLC.