An S Corporation (S Corp) is a corporate entity form that elects to be taxed under Subsection S of the Internal Revenue Code (IRC). A business does not have to organize as a corporation to be taxed under subsection S of the IRC. As such, many of the tax benefits associated with a S Corp also apply to non-corporate entities. To make this tax election, the corporation must meet several requirements. Below, we explain everything you need to know about S Corps and S Corp tax benefits.
Formation of an S-Corp
A corporation is a business entity organized under state law. The first step in incorporating your business is to choose the state of incorporation. You can incorporate in any state, but you will need to register as a foreign corporation in every other state in which you carry on business. The first step in incorporating is filing the articles of incorporation with the state secretary of state’s office. Once approved, the incorporators will receive a certificate of incorporation or a charter indicating that the corporation now exists. During the initial meeting of directors (or through unanimous written consent), all directors must vote unanimously to elect taxation of the corporation under subsection S of the IRC. Once authorized, the directors will authorize a company agent to request a Federal Employer Identification Number (FEIN) and make the election to be taxed under Subsection S by filing Form 2553 with the IRS. The company will need to attest that it meets all of the eligibility requirements for this tax election.
Ownership and Control of an S-Corp
The ownership structure of an S Corp consists of shareholders, directors, and officer. Frequently, the same individuals will hold all three positions at the same time. This is common with smaller, closely-held companies. To qualify as an S-Corp there can be no more than 100 shareholders. Also, all shareholders must be human beings or certain types of holding trusts or estates. Further, all shareholders must be US citizens. There is an exception that allows foreigners to own an interest in an S Corp if it is held in an Electing Small Business Trust. The S Corp can issue only one class of stock — generally common stock.
Personal Liability Protection for S-Corp Owners
As with all corporations, shareholders of an S Corp have personal liability protections for the debts and obligations of the corporation. The risk to the shareholders of being held personally liable increases if the S Corp is closely held and the shareholder also serves as director and officer. This is because there is less separation in the roles of each individual. An officer and director may be liable for her own torts of for malfeasance in managing the company. Also, in closely-held companies, it is more likely that courts will impute a duty of care to shareholders to act in the best interest of the company or other shareholders.
Compensation and Taxation of an S-Corp
S Corps are pass-through tax entities. The S Corp generates revenues, subtracts the costs of doing business, and the result is corporate profit. One of the primary costs to the S Corp will be the salaries of corporate employees. Unlike the owners of a partnership-taxed entity, the owners of an S Corp can work for the corporation and receive a salary. In partnership-taxed entities, owners must receive any compensation for services as a distribution of profits. Any profits of the S Corp automatically flow through to the shareholders for tax purposes. This makes S Corps pass through tax entities. This is true even if the corporation does not actually distribute the profits to the shareholders as dividends. The shareholders are still subject to taxation on their share of the profits. The shareholders share of profits is based entirely on her percentage of ownership. Unlike in partnership-taxed entities, there is no special allocations of profits allowed in an S Corp. The distribution of profits to shareholders is taxed at the shareholder’s ordinary income tax rate. As of 2018, the amount of profits taxable to shareholders automatically receives a 20% deduction. This new rule makes S Corp status an attractive entity form. This is an S Corp tax benefit. Also, S Corp profits are not subject to Federal Income Contribution Act (FICA) taxes. FICA is made up of Medicare and Social Security taxes.
A shareholder’s basis in the corporation (the amount the shareholder paid for her ownership interest) is the value of cash or property contributed to the S Corp in exchange for the ownership interest. The shareholder’s basis increases by her share of the business profits and by the additional contributions she makes to the business. Her basis is decreased by the distribution of profits that she receives or her share of the company’s losses. As such, if an investor does not take a dividend from company profits, her basis in her company shares go up. Likewise, if the company sustains losses, the basis in her shares diminish. The shareholder will not actually realize a profit or loss in this scenario until the shares are eventually sold. If the shares sell for an amount in excess of her basis, she will be taxed at a capital-gain rate on the excess.
Each state has its own rules for income taxation of business entities. There are many S Corp tax benefits. If you are doing business in other states, you must also register in those states as a foreign corporation. Most states follow the federal rules and do not tax the profits of the S Corp. However, there are a few states that assess an income tax on the S Corp itself in addition to the taxes paid by shareholders.
LawTrades Knows Business Entities
Forming a business entity, such as an S Corporation, and setting it up for operations can be tricky. Let the legal professionals at LawTrades assist you in your efforts when incorporating your business.