What Is an S Corporation? Taxation, Requirements, Benefits & Filing

An S corporation is one of the most popular structural choices for small-to-midsize businesses seeking to benefit from a U.S. corporation. It is not a separate legal entity and is elected under Subchapter S of the Internal Revenue Code. It offers a hybrid structure that combines a corporation's limited liability with a partnership's pass-through taxation.

Under it, businesses generally aren't subject to regular federal corporate income tax; profits pass through to shareholders, who pay tax when filing their returns. However, certain federal and state taxes may still apply. Not everyone can elect S corporation status; you must meet certain requirements.

Want to know more about an S corp, its requirements, taxation, and how it works? Then you are on the right page. Scroll down and gather all the information associated with an S corporation.

What Is an S Corporation?

An S corporation is a popular business structure in the U.S. elected under Subchapter S of the Internal Revenue Code. This tax status is available to eligible domestic corporations and certain other eligible domestic entities, including LLCs that qualify for and elect corporate tax treatment. Under it, the business itself remains the LLC or corporation; the status only changes the tax obligations. An S corp provides a hybrid structure combining the limited liability of a corporation with the pass-through taxation of a partnership.

Under pass-through taxation, the business itself generally does not pay regular federal corporate income taxes. Instead, the shareholders report their share of business profit or income on their personal tax returns and pay tax at individual rates. This generally avoids double taxation on corporate income, although certain entity-level taxes may apply.

Further, an S corporation is not a separate legal entity like a company. The IRS describes it as a corporation that passes corporate income, profits, losses, deductions, and credits through to shareholders for federal tax purposes.

This was all about an S corporation. Next, let's look at the requirements and eligibility for forming one.

S Corporation Requirements and Eligibility

Under IRS §1361, the IRS sets specific criteria you must meet to form an S corporation. Miss one and you may not qualify for S corp status. Common eligibility requirements for an S corporation include:

• Your corporation should be a domestic entity under the applicable federal tax rules.
• It should not have more than 100 shareholders, subject to applicable family aggregation rules.
• Shareholders must be eligible under IRS rules. Nonresident aliens generally cannot be shareholders, but eligible resident aliens may qualify.
• Shareholders must be individuals, certain estates or trusts, or certain eligible tax-exempt organizations.
• It should have only one class of stock.
• It should generally follow a calendar year, unless an exception applies.
• It should not be an ineligible corporation type, such as certain insurance companies, financial institutions, and domestic international sales corporations.

Who Cannot Be an S Corp Shareholder?

Here is all about who generally cannot be an S corp shareholder:

• Nonresident aliens
• Corporations and partnerships
• LLCs that are not eligible shareholders under the applicable tax-classification rules

An eligible LLC may itself elect S corporation status if it meets the IRS requirements.

Additionally, eligibility for an S corporation is not checked only once. For instance, if a shareholder inadvertently transfers their interest to an ineligible individual, or dies and their interest passes to a trust that does not qualify, the S corp election may terminate. However, certain qualifying trusts are permitted to hold S corporation shares.

100-Shareholder and One-Class-of-Stock Rules

Generally, an S corporation cannot have more than 100 shareholders. Special family aggregation rules can affect how to count shareholders for this purpose. Additionally, an S corp has only one class of stock. The IRS states that outstanding shares should offer identical rights to shareholders for distribution and liquidation proceeds, although differences in voting rights may be permitted.

So, this covered the S corporation eligibility requirements. Moving forward, let's learn how this corporation is taxed.

How Is an S Corporation Taxed?

As mentioned earlier, an S corporation for federal tax purposes operates as a pass-through entity. As a result, the business calculates its income, deductions, expenses, and other relevant items and files a tax return using Form 1120-S.

After that, generally, the relevant tax items pass through to shareholders based on their ownership interest. The company provides each shareholder with Schedule K-1. The schedule reflects their share in specified S corporation tax items. Then the shareholders report those items in their individual tax returns and pay tax on them. They generally must report their allocated share of taxable income even if they do not receive that amount in cash. The tax treatment of actual distributions depends on the applicable rules, including the shareholder's stock basis.

However, the S corporation itself is not completely exempt from the federal tax system. In applicable circumstances, certain passive income and built-in gains are taxable at the entity level. To better understand how an S corporation works, let's look at an example.

For instance, after allowable wages and deductible expenses, an S corporation has around $150,000 taxable business income. Under this, two shareholders own 50% each. Subject to the applicable rules, each receives $75,000 in pass-through income.

However, if the corporation distributes only $50,000 in cash to each shareholder, that does not limit their taxable income from the corporation to $50,000.

S Corporation Salary and Distributions

If you are a shareholder in the S corporation and perform substantial services for the business, generally you are considered an employee of the corporation. This means the corporation pays you wages through payroll. Additionally, like other employees, your salary from the corporation will also be reported on Form W-2.

As a shareholder, you receive a distribution when the S corporation transfers property or money to you because you have an ownership interest.

Now, suppose you are an owner in the S corporation and work full-time in the business. The business generates $150,000 before paying you compensation. Here, you cannot simply state that you will pay yourself $5,000 as salary and take the remaining amount as a distribution to avoid payroll taxes.

Based on the services you performed, you need to determine a reasonable salary. For this, you can use the relevant considerations:

• Training and experience
• Time devoted to the business
• Duties and responsibilities
• Comparable compensation
• Payments to other employees
• Compensation agreements
• How the revenue is generated by the business

There is no universal percentage to calculate a reasonable salary that works for every S corporation. Now, moving ahead, let's look at how to elect S corporation status.

How to Elect S Corporation Status?

Here is how you can elect S corporation status:

• Form your LLC or corporation at the state level. An LLC generally files articles of organization, while a corporation generally files articles of incorporation or the equivalent state formation document. After that, apply for an Employer Identification Number (EIN) from the IRS.
• Check whether you meet the S corporation eligibility requirements. You need to satisfy every S corporation requirement, including domestic entity status, eligible shareholders, shareholder count, entity type, and stock class. Nonresident aliens generally cannot be shareholders.
• Fill out IRS Form 2553. To complete the form, you need your business name, incorporation date, EIN, fiscal year-end, state of incorporation, and proposed effective date.
• Get the signature from every shareholder. Make sure all required shareholders sign the form.
• Fill out Form 2553 with the right IRS service center. Mail or fax the form to the address or fax number stated in the form. If you mail the form, send it via certified mail and keep the receipt; if you fax it, keep the confirmation page.
• If everything goes well, you will receive a CP261 confirmation notice from the IRS. This process generally takes around 60 days. If you don't receive the notice after that, contact the IRS using the contact information in the relevant IRS guidance. Additionally, keep the CP261 safe, as it is evidence of S corp tax status.

Form 2553 Deadlines

Here is what you should consider when filing Form 2553:

• If you already have an existing corporation or eligible LLC, then you should generally file the form no later than 2 months and 15 days after the beginning of the tax year for which you want the S corporation election to take effect. For a calendar-year entity seeking an election effective from the beginning of the year, the deadline is generally March 15.
• If you are a newly formed entity, calculate the deadline based on the beginning of the tax year for which the election is intended to take effect, following the Form 2553 instructions.
• If you miss the form deadline, the election does not automatically shift to the following tax year. You may qualify for late-election relief if you meet the applicable IRS requirements.
• Also, under Revenue Procedure 2013-30, if you missed the deadline because of reasonable cause, the IRS may offer late-election relief. To qualify, your business must meet the applicable requirements, including reasonable cause for the late filing and diligent action to correct the failure. The entity and its shareholders may also need to show that they reported consistently with the intended S corporation status for the relevant period.

So, this is how you can elect S corp status. Now, moving forward, let's look at the compliance requirements after obtaining this status.

Compliance Requirements After Electing S Corp Status

You need to fulfill the following compliance requirements after electing S corp status:

• Annual Tax Filing: Although an S corporation generally does not pay regular federal corporate income tax on its income, it still must file taxes using Form 1120-S. Even if your business generates no income, you generally still need to file this form every year. The return is generally due by the 15th day of the third month after the end of its tax year. For a calendar-year S corporation, the deadline is generally March 15, subject to weekend and holiday rules. You can also request an extension for filing the federal tax return using Form 7004.
• Schedule K-1: The S corporation should prepare and distribute Schedule K-1 to every shareholder in the business by the applicable filing deadline. The schedule contains the proportionate share of income, credits, deductions, and other tax items of each shareholder.
• Payroll Compliance: If you are a shareholder and also work as an employee in your S corporation, you need to consider the payroll process as well. As a result, you must withhold and remit payroll taxes, file quarterly payroll returns using Form 941, and prepare annual wage reports using Form W-2 and Form W-3, as applicable.
• State-Level Filings: Depending on where your business is formed, registered, or conducts business, you may also need to file a state income tax return, submit annual reports, or pay a franchise tax. For instance, New Jersey, California, and New York have their own state-level tax and S corporation election rules. So, before filing a tax return, check these requirements, too.
• Corporate Formalities: If your S corporation is a corporation rather than an LLC, you need to meet the applicable state-law and governing-document requirements. These may include holding shareholder and director meetings, keeping corporate records, maintaining minutes, and avoiding commingling business and personal funds. Failing to meet these requirements does not automatically make shareholders personally liable, but it may contribute to a court's decision to impose liability under applicable state law.

These are the compliance requirements you must follow after gaining S corporation status. Moving further, let's know the advantages and disadvantages of forming this entity.

Advantages and Disadvantages of an S Corporation

An S corporation offers several benefits to its owners; however, it may not suit every business. With that in mind, let's look at the S corporation's advantages and disadvantages.

Advantages of an S corporation

• Generally not liable for regular federal corporate income tax. Profits directly pass through to the personal returns of the shareholders, although certain entity-level taxes may apply.
• Being a shareholder, if you work in your U.S. corporation, you generally pay payroll taxes on your salary, not on distributions. However, the IRS may reclassify payments as wages if the compensation is not reasonable, and distributions may have separate income-tax consequences.
• Offers personal liability protection. Generally, shareholders are not liable to pay business debts or legal judgments using their money.
• If the business faces losses, shareholders may, subject to applicable basis, at-risk, passive activity, and excess business loss rules, use them to offset other income on their personal returns.
• An S corp has the structure and formality of a corporation, useful for financing, business, and contract relationships without the regular federal corporate income tax.

Disadvantages of an S corporation

• An S corp has strict eligibility rules. These include a 100-shareholder limit, restrictions on eligible shareholders, including the general prohibition on nonresident alien shareholders, and a one-class-of-stock requirement.
• One class of stock only. It generally cannot offer preferred shares with different distribution or liquidation rights, although differences in voting rights may be permitted.
• Working owners in an S corp must pay themselves a reasonable salary for their services, which means payroll filings and costs.
• Ongoing compliance costs, such as Form 1120-S, Schedule K-1s, and payroll filings, add expenses that a default LLC doesn't even require.

These are the S corporation advantages and disadvantages. Now, moving forward, let's learn the difference between an S corporation, an LLC, and a C corporation.

S Corporation vs LLC vs C Corporation

The table below showcases the differences between a C corporation, an S corporation, and an LLC.

Further, an LLC is a business entity created under law; a C corporation is a separate legal business entity; and an S corporation is a special tax status taxed under Subchapter S. Moving ahead, let's know when forming an S corporation makes sense.

When Does an S Corporation Make Sense?

An S corporation makes sense when your business consistently generates profits, and you actively work in the company. For instance, a U.S. consulting business that operates as a single-member LLC. Assume it generates enough profit. In this situation, forming an S corp allows you to pay employees a salary for their work and distribute additional earnings to shareholders.

However, before forming an S corporation, compare the payroll tax savings with the additional costs. The additional costs include:

• Running payroll
• Maintaining strong accounting records
• Preparing Form 1120-S
• Fulfilling state requirements
• Tracking shareholder basis
• Taking help from a professional expert when needed

Further, an S corp may not be favorable if profits after reasonable owner compensation are insufficient to justify the additional costs, you need nonresident alien shareholders, you want multiple classes of stock with different economic rights, or you want to avoid administrative burden.

So, whether you should form an S corp depends on your ownership, business profit, growth plans, compensation, and compliance costs.

Final Thoughts

Lastly, an S corporation is a special tax status that allows eligible businesses to pass specified income, deductions, losses, and credits through to shareholders for federal tax purposes while retaining the underlying legal entity. Whether you should choose an S corporation depends entirely on your ownership, business profits, need for eligible shareholders, and whether you meet the requirements. However, before electing S corporation status, weigh both sides of the decision: ongoing compliance obligations and potential tax treatment.

Unsure whether to opt for S corporation status? Connect with Savetaxs for personalized guidance based on your situation, and clear up any doubts. We can also help you form an S corporation and manage the associated tax obligations.