Forming an S corporation can come with advantages and disadvantages for shareholders, learn what key considerations you need to know.
As you’re beginning to grow your small business, questions often arise around how to structure your organization. If you’ve heard the terms C corporation and S corporation tossed around, it can be confusing to sift through what it all means. More importantly, how do you know what’s right for your business?
This overview of S corporations outlines some of the key considerations you need to know. As you move forward, bear in mind that consulting an attorney is the best way to get advice for your specific needs around S corporations.
Psst… We developed an eBook for entrepreneurs to help with the many challenges of starting and running a business. Learn more and download the Fearless Confessions eBook.
S corporations are eligible C corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The profits and losses can then be passed through the S corp to the individual shareholders for federal tax purposes. This allows S corporations to avoid double taxation on their business income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
The first steps to forming an S corp are identical to those of a C corp, which include coming up with a name, filing the Articles of Organization with the Secretary of State, and then following the rules set by the government. Of course, the actual process may vary depending on the state.
Working shareholders of an S corp will only pay self-employment taxes on their earned income and not any distributions they receive as a shareholder.
Once the corporation has formed—and so long as there are fewer than 100 shareholders—all individual shareholders can submit a Form 2553, the Election by a Small Business Corporation, to the IRS. This document will have to be signed by all shareholders of the corporation for the IRS to recognize it.
When forming an S corporation, the following rules have to be satisfied:
The company must be a domestic corporation that elects to be treated as one.
It cannot have more than 100 shareholders.
The shareholders must be either individuals, estates, exempt organizations (such as a 501c3) or certain types of trusts.
None of the shareholders may be nonresident aliens.
It must have only one class of share. While there can be different voting rights for shares, they must all possess the same rights for distribution and events of liquidation.
It follows the other specific rules that the IRS explains in its Instructions for Form 2553.
The IRS mandates that Form 2553 be completed and filed under the following three scenarios:
Between 15 days and two months after the beginning of the tax year has taken place
Any time during the year prior to when the S corporation is going to take effect
If the corporation has just been formed, the corporation has 15 days and two months from the beginning of its first tax year to file for S corp status.
As with a regular corporation—or even a Sole Proprietorship or LLC—there are certain tax forms that the company has to submit. Specifically, the IRS requires Form 1120S, which is the S corp’s annual tax return. Along with this, companies should also file Schedule K-1, which shows how the profits and losses are allocated to the owners.
Submitting all those forms leads to one of the key reasons someone may choose to form an S corp: tax breaks.
Under an LLC, the members are considered working owners and must pay self-employment taxes on any self-employment income. However, working shareholders of an S corp will only pay self-employment taxes on their earned income and not any distributions they receive as a shareholder.
There’s a caveat though. The IRS mandates that any shareholder that actually works for the S corp has to receive a “reasonable salary.” This is because personal income is taxed at a higher rate than distributions from a corporation. The IRS wants to ensure that the shareholders are not taking their entire pay in distributions when they are also employees of the company.
As an owner, you can avoid having your business taxed twice. With a C corp, the profits are taxed first as the corporation and then all distributions are taxed. S corps avoid this.
The other advantage is that there are no self-employment taxes on distributions, which allow the shareholders to minimize their tax hit significantly.
Transfer of ownership is another advantage. If more than 50% of an LLC is transferred, the entire entity can be terminated. On the other hand, shareholders of an S corp can sell their portion of the business without it resulting in any termination.
First, there can only be 100 shareholders. This isn’t problematic when you’re first starting out, but if your idea of a liquidation event is to go public, there are likely to be many more than 100 shareholders. This can, therefore, interfere with your ability to raise money from a venture capitalist.
Related post: To Keep a High-Growth Company on Track, Scale Wisely
The other disadvantage is the “reasonable salary” requirement. The IRS gives little guidance on what constitutes a reasonable salary, which can create a lot of ambiguity. However, the IRS has provided some factors that can be used to determine whether salary is reasonable.
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
The use of a formula to determine compensation
One easy way to come up with a salary estimate is to use Salary.com to search for the job that most closely resembles the position in the same geographic area. You should also be aware of what similarly situated employees are making. While it might be appealing to minimize salary in favor of more favorable distribution taxes, it’s not worth dealing with the IRS.
If your operation is relatively small in size and doesn’t have more than 100 shareholders, becoming an S corp could be a great option. Avoiding double taxation is great, and not having to pay self-employment tax is an incredible way to save tens of thousands of dollars.
However, if you plan to go public, you’ll have to deal with the double taxation and stick to a regular C corp.
Monthly tips on running a business in your inbox.
Justworks is a technology company that levels the playing field for all small businesses. Through our software and as a partner, we help our customers take care of their teams, streamline their operations, and navigate the complex aspects of managing a workforce with confidence.
Scale your business and build your team — no matter which way it grows. Access the tools, perks, and resources to help you stay compliant and grow in all 50 states.