What is an S Corporation?

An S Corporation is a corporation or LLC formed under state law that has made an election with the IRS to be treated as a pass-through entity for federal income tax purposes. An S Corporation’s income is not taxed as the entity-level; instead it is passed-through to the shareholders who report and pay taxes on the amounts allocated to them. This allows S Corporations to avoid any possibility of double taxation on the corporate income.

Can only corporations make an S Corporation election?

Although the S Corporation election is often made by a corporation, it can also be made by an LLC. An LLC can elect to be taxed as a corporation. Once this election is made, it can make an election to be treated as an S corporation.

Does an S Corporation ever have to pay any tax?

While most of the S Corporation’s income, losses, deductions, and credits are passed through to the shareholders for federal tax purposes, the corporation may be liable for tax on certain passive income and built-in gains.

Also, not every state follows the federal rules when taxing S corporations.  Some, such as California and Illinois, impose a tax at the entity level.

Who should form an S Corporation?

Every business owner should consider operating the business in a manner that shields the owner’s personal assets from the liabilities, debts and judgments of the business. An S Corporation may be the best choice if the owners want to pay both salary and dividends in order to lighten their overall tax burden.

Who can be an S Corporation shareholder?

Unlike regular corporations, S Corporations must follow strict rules regarding who can be a shareholder. Only individuals, certain trusts, and estates can be shareholders. Partnerships, corporations and non-resident aliens cannot be issued shares.

Are there limits on the number of shareholders in an S Corporation?

An S corporation cannot have more than 100 shareholders, although certain family members can be counted as a single shareholder

What legal documents are required to form an S Corporation?

The first step in creating an S corporation is to incorporate by filing Articles of Incorporation or Articles of Organization with the state selected as the formation state.  Once the Articles are approved by the state, the corporation files Form 2553, Election by a Small Business Corporation, with the IRS. This form must be signed by all the shareholders.

When must Form 2553, Election by a Small Business Corporation, be filed?

A corporation can elect to become an S Corporation at any point during its life, but most elect the status beginning with their first tax year.  To make the election for the first year, Form 2553 must be filed within two months and 15 days after the beginning of the business’s tax year. An election for the next year can be filed at any time during the preceding year.

Does an election have to be made at the state level?

Most states accept the federal election statement for state tax purposes. However, a few states, such as New York, require a separate state election.

Do I need a registered agent for my S Corporation?

Yes, you must appoint a registered agent for your S Corporation. All the state requirements imposed on regular for-profit corporations apply to S corporations. The initial registered agent is appointed on the Articles of Incorporation or Articles of Organization (for an LLC). If you do business in any states other than your formation state, you will need to appoint a registered agent in each of those states, and you must maintain a registered agent in each state until you dissolve the company or withdraw from the state.

Do I need an attorney to form an S Corporation?

It is recommended that you engage an attorney to form the legal entity (corporation or LLC) that will make the election. An attorney, CPA, or other tax professional can assist you with making the election.

Which is the best state for forming an S Corp?

There is no “one best state” to form any corporation.  In general, most small businesses incorporate where the owners live or where the company is doing business in order to reduce initial and on-going costs and compliance responsibilities. If you incorporate in a state other than the one where you are doing business, you will immediately need to apply for a certificate of authority to operate in that state (also known as “Foreign Qualification”). And, going forward, you will have to file annual reports (and pay the annual report filing fees) in both the formation state and the state where you are registered to do business.

What is the difference between an S Corp and an LLC?

Both an LLC and an S Corporation are considered “pass-through” tax entities.  That means the company does not pay any tax on its taxable income. Instead, the income, losses and tax items (such as depreciation deductions) are passed through to the members or shareholders, who report these items on their personal tax returns

One significant difference is that all of the LLC’s profits are considered the self-employment income of the members—and the members are liable for self-employment tax on their shares. In contrast, an S corporation can pay a salary to the owners who operate the business and pay the reminder of the profits to them as dividends. This greatly reduces the amount of employment tax liability and can result in substantial savings.

Another difference between an S Corp and LLC is that an LLC can allocate profits, losses and tax items however the members agree.  A corporation must allocate these items based strictly on the number of shares owned.

What is the difference between a C Corp and an S Corp?

A C Corporation is a separate tax-paying entity, unlike an LLC and an S Corporation.  A C Corporation reports its own income, expenses, losses and tax items on its own return and pays taxes based on the corporate tax rate. Any money that a shareholder receives is distributed as salary or dividends. Profits distributed as dividends are actually taxed twice: once as corporate income on the corporation’s tax return and, again, as income on the shareholder’s tax return.

However, there are tax planning strategies—such as accumulating earnings—that are not available to an LLC or an S Corporation that may offset concerns regarding “double taxation of dividends.” Talking with a tax advisor can help you sort through the options and determine what is best for your circumstances.