Are you thinking of starting an S Corp but you’re unsure about all the steps required to form one? If that’s the case, you’ve come to the right place.
In this article, you’ll find everything you need to know regarding how to start an S Corp. We’ll first give you a clear definition of what an S Corp is and go over some of the benefits and drawbacks of starting an S Corp to give you a better idea of the type of company you’re getting yourself into.
In addition to that, we offer a detailed section where we go over every step required to form an S Corp, accompanied by a few optional but extremely useful steps in case you want to go the extra mile. At the end of our article, you’ll find an FAQ section in which we answer some of your most pressing questions.
Without further ado, it’s time to delve into what an S Corp is.
What Is an S Corp?
An S Corp is a tax classification in which the corporate income, losses, and credits are passed through to the shareholders for taxation purposes. In other words, it has pass-through taxation – the business income is taxed on the shareholders’ individual tax returns. Its taxation policies are one of the most appealing aspects of S corporations, so many entrepreneurs prefer it over other business structures.
S Corps get their name from the subchapter “S” of the Internal Revenue Code, where the taxation designation is detailed. Apart from S Corps, there are many other types of corporations, such as C Corps, and non-profit corporations.
There are several requirements you need to fulfill to qualify for becoming an S Corp, such as being a domestic business, having no more than 100 shareholders, and having only one class of stock.
Benefits of Starting an S Corp
If you’re reading this article, chances are you’re thinking about starting an S Corp. If you’re still not convinced that it’s the right business structure for you, here are some of the best benefits you’ll get if you opt for this type of corporation.
You won’t be surprised to learn that S Corps, just like all types of corporations, provide limited liability for its shareholders. What this means is that creditors can’t go after their personal assets in the event of a claim, lawsuit, bankruptcy, or debt. Their personal assets include anything from real estate to bank accounts.
We touched on the fact that S Corps have pass-through taxation, but how will this benefit the owners?
Pass-through taxation means that any profit, loss, or credit is directly passed through to the owners as opposed to being taxed on a corporate level. Unlike some other types of business structures, there is no double taxation – both on a personal and corporate level, which is incredibly useful for start-ups.
Another favourable taxation policy is that there is no accumulated earnings tax, which some other types of corporations like C corps are subject to.
Easy Ownership Transfer
With sole proprietorships, in the event of the owner’s death, the business ceases to exist. Contrary to sole proprietorships, the interests in S Corps can be transferred without any problems in case one of the owners decides to no longer participate in the business. All this can be accomplished without triggering any adverse tax consequences, which is a big advantage.
Cash Method of Accounting
Another benefit many entrepreneurs enjoy is that S Corps have a cash method of accounting, as opposed to an accrual method of accounting. S Corps only have to comply with the accrual method of accounting if they have some kind of inventory.
In addition to the abovementioned benefits, S Corps also enjoy the benefit of being seen as more credible. They attract more potential investors and clients due to the perceived formality of the business.
Other types of business structures, such as sole proprietorships, are often in danger of being seen as less credible due to the fact that they are not incorporated.
Disadvantages of Starting an S Corp
We saw the major benefits of starting an S Corp, so it’s time to explore some of the disadvantages associated with this type of structure.
S Corps Can Be Quite Pricey
The main disadvantage of forming an S Corp is that it requires a lot of formation and ongoing expenses, so you’ll need quite a substantial budget to start. Many of the steps required to form an S Corp entail a certain fee, such as hiring a registered agent, filing articles of incorporation, and hiring legal consultation if you decide that you want to consult someone.
Additionally, there are many ongoing fees that you need to pay on a yearly basis, such as filing annual reports and paying taxes.
S Corps operate with stock, and there are a few restrictions you should be wary of.
For instance, you can only have one class of stock in an S Corp, which is a turn-off for some entrepreneurs. Additionally, there are restrictions in the number of shareholders you can have in your S Corp – you can’t exceed more than 100 shareholders.
Apart from stock-related limitations, there are also some qualification requirements you need to comply with. To exemplify, to qualify to become an S Corp, you’ll have to comply with quite a few rules and regulations. For instance, only individuals and some types of estates and trusts can be shareholders.
The Secretary of State’s office enforces many ongoing formalities that all corporations have to bear in mind, although some to a lesser extent. If you make any mistakes regarding the allocation of profits and losses, or electing a board of directors, the IRS might terminate your S Corp Subchapter S status, so pay careful attention to all the regulations required in your state.
How to Start an S Corp
Now that we’ve gone over all the benefits and drawbacks of forming an S Corp, it’s time to elaborate on all the steps required to form an S Corp.
First things first, it’s important to clarify that there are two main ways you can start an S Corp:
- By starting an LLC and choosing to be taxed as an S Corp from the IRS
- By forming a corporation and selecting an S Corp status from the IRS
In this section, we’ll explore the latter, which includes all the steps prescribed by the IRS.
Choose a Business Name
Unsurprisingly, the first step in forming an S Corp, or any type of business for that matter, is deciding on the name. There are quite a few rules you’ll need to keep in mind when choosing a business name; for starters, it has to be a unique name that’s not taken by any other business. To ensure that this is the case, you can do a trademark search or search an online engine.
There are also some words you’re not allowed to use in your name, depending on the state. To find out what these words are, you can request a list of words from your Secretary of State’s office.
File Articles of Incorporation
One of the most crucial steps in starting an S Corp is filing articles of incorporation. The articles of incorporation is a document that includes information regarding your business and personal information about those involved in the business, such as the names of the shareholders and their personal information. This document is also known by the names Certificate of Organization and Certificate of Formation. You can access a form online and fill it out. Alternatively, if you’re more old school, you can also fill it out on paper.
Keep in mind that some states, like California, require you to complete two separate forms, so double-check the precise regulations for the state where your business will be located. Another thing to keep in mind is that filing articles of incorporation does come with a fee. The fee varies largely from state to state, but it can be anything from $50 to a couple of hundred dollars.
In order to become an S Corp, in addition to filing articles of incorporation, you’ll also need to submit Form 2553, Election by a Small Business Corporation, which should be signed by every shareholder in your company. If you’re unsure about how to proceed with this, there are detailed instructions on the IRS website that can help guide you through this process.
Once you file your articles of incorporation, you can proceed to the following steps. In case some information included in the articles changes, you’re obliged to amend the information in your original files.
Appoint a Board of Directors
The next step in forming an S Corp is appointing a board of directors and officers.
Every corporation requires a board of directors to help with the operations of the business and make the major decisions in the company.
Apart from selecting a board of directors, you’ll also need to appoint officers. The role of the officers is to carry out all the policies selected by the board of directors and take part in making small, day-to-day decisions.
Hire a Registered Agent
The next step to forming an S Corp is optional – if it’s within your budget and you’d like to save some time and energy, you have the option of hiring a registered agent. A registered agent is a business or an individual whose responsibility is to receive important legal notices and documents on your behalf in relation to your business. There are many perks to hiring a registered agent, such as more flexibility in your working schedule, since you will no longer be obliged to be in the office during working hours.
The costs of registered agents vary from state to state, but, on average, it can cost anywhere from $200 to a couple of hundred dollars per year.
Obtain an Employee Identification Number
A crucial step in forming an S Corp is obtaining an Employee Identification Number (EIN), also known as a Federal Employer ID Number (FEIN). Every business needs a unique EIN – think of it as your business’ own Social Security Number. The good news is that obtaining one doesn’t cost a penny. All you need to do is submit an online application on the IRS website.
Get any Licenses and Permits
Depending on the type of business you’re thinking of conducting, you might need a license or a permit to operate it. There are several different types of licenses, such as federal, state, and local business licenses. Different businesses require different types of licenses, so do your research to double-check if your business needs one. If you determine that you need one for your business, the next step is to apply for one with your state.
Create an Operating Agreement
Operating agreements are an incredibly useful tool to help your business remain organized and professional. An operating agreement is essentially a document that details all the operations and management of your business – it states who bears the responsibilities for different aspects of your business, how the profits of your business are divided, and the precise division of the ownership of your business. Just like its name suggests, it’s where you lay out all the details regarding the operation of your business.
While some states don’t require businesses to create an operating agreement, it’s quite useful to have in case you need to liquidate your business or hold fellow members responsible. If you’re unsure about how to create an operating agreement, you can always hire a legal consultant or obtain a template on the Internet.
Once you finish all the legal requirements needed to operate a business, you’ll be ready to issue the first stocks. Before you do so, the board of directors you’ve appointed will need to approve the number of shares initially issued. After you’ve been granted permission, you can choose to provide a report for any potential shareholders you might have.
File Tax Forms
Last but not least, the final step to having your S Corp up and running is to file Form 2553 with the IRS. Once you’ve completed this step, your business will be ready to go!
Should I Make my LLC an S Corp?
Many entrepreneurs are tempted to make their LLC into an S Corp to provide opportunities for growth for their business. Doing so is a great idea if you have a more complex company or you’d like to operate with a board of directors and have shareholders. If your business is on the smaller side and you don’t have big plans for it, then remaining an LLC might have its benefits.
What Are the Eligibility Requirements for Starting an S Corp?
There are several requirements your business needs to complete to become an S Corp. For instance, you must have a domestic business – foreign businesses are not allowed. You must have one type of stock and you can’t have more than 100 shareholders. In addition, all the shareholders must be individuals and residents of the United States.
Can I Make Myself an S Corp?
No, individuals can’t become an S Corp. You would first need to create an LLC or a C corporation and proceed to apply for S Corp status.
We hope you found our article on how to start an S Corp useful and that now you feel more prepared to delve into this venture.
There are many reasons why you might want to opt for an S Corp, such as pass-through taxation, limited liability, and more credibility in the eyes of potential customers and investors. There are various steps required to form an S Corp, like applying for an EIN and issuing stock. Additionally, there are some optional steps that can make the experience much easier, like forming an operating agreement.