You might be thinking about forming an S corp from scratch and are curious about the potential advantages and disadvantages that are innate with this business structure. Likewise, you might be thinking of expanding your existent business and incorporating your LLC as an S corp. Whatever the case might be, our article will provide answers to “What is an S corp” and similar questions you might have regarding the formation of this business structure.
After defining what an S corp exactly is, we’ll explore all the potential benefits and drawbacks that come with forming an S corp to help you make an informed decision about whether this structure is compatible with the goals of your business. We’ll also lay out the differences between an S corp and a C corp, and the differences between an LLC and an S corp. Additionally, we’ve included a section where we briefly go over some of the steps required to form an S corp, as well as a detailed FAQ section.
With that said, let’s start by explaining what an S corp is.
What Is an S Corp?
An S corp is a type of corporation that provides some tax advantages and meets the Internal Revenue Code Requirements. It gets its name from the Subchapter S of the Internal Revenue Code that deals with taxation. S corps have a board of directors, officers, executives, and members/shareholders who are offered liability protection. With S corps, you will receive the best of both worlds – you will enjoy all the benefits of incorporating without suffering some of the tax burdens of larger companies.
S corporations have some limitations. For instance, the shareholders must be individuals or other organizations that have specific taxation. Additionally, they need to have 100 shareholders or less to get some of the advantages of incorporation.
Advantages of Forming an S Corp
Now that we’ve defined what S corps actually are, it’s time to go over some of the potential benefits you could enjoy should you choose this type of business structure.
As we mentioned earlier, one of the biggest advantages when it comes to forming an S corp is having protection for your personal assets. Operating any kind of business is a risk, so it’s helpful to know that your personal assets, like your house and your car, will remain protected in case your business undergoes a lawsuit or a financial loss.
It’s important to note that there are certain exceptions to having limited liability depending on the type of business you’re conducting, so it’s important to complete your research beforehand and get informed.
No Double Taxation
Unlike some other types of business structures, forming an S corp doesn’t come with double taxation. Essentially, this means that you won’t be paying separate business taxes and personal taxes, or any federal taxes on a corporate level. Both the losses and the profits will be passed through to you. This is a crucial advantage for businesses that are just starting out and are in the start-up phase.
Make sure you check out the individual guides for your state to ensure that you’re correctly informed about the taxation in your country.
Another important benefit that comes with forming an S corp is that it’s easily convertible into an LLC or a C corp, in case the owners want to change the business structure. Since S corps and C corps have so many similarities, all that’s required for the owners to do is file with the Internal Revenue Service. Needless to say, some states have more formalities than others, so it’s important to check with your state prior to beginning this journey of structural transformation.
Additionally, if an S corp is terminated, the amount of paperwork that needs to be done is much smaller than that of other business structures like LLCs.
Easy Ownership Transfer
Another process that’s relatively easier for S corps is the transfer of ownership. In case a member wants to transfer their interests to another party, they can do so without the burden of additional taxation, which is always a plus.
Generally speaking, S corps are seen as more credible and trustworthy than partnerships and sole proprietorships. Being perceived as more credible helps immensely when it comes to reaching potential customers, investors, and even employees.
No Payroll Taxes
When salary and dividend payments are made to the owners, they’re not subject to payroll taxes. Additionally, S corps always have the option of deducting the cost of the wages when the income is passed through. This results in a lower tax bill.
When it comes to retirement plans, the prospects of S corps are incredibly appealing. On average, employees are paid up to 25% of their earnings during their retirement.
Cash Method of Accounting
Unlike other business entities, which are still obligated to use an accrual method of accounting, S corps are allowed to use the cash method of accounting. The cash method of accounting includes recording payment receipts when they’re received and recording all the expenses when they’re actually paid. On the other hand, the accrual method takes into account the revenue and expenses only when they’re incurred.
Disadvantages of Forming an S Corp
To get the full picture and determine whether an S corp is a viable option for you, it’s important to also consider some of the drawbacks that come with forming an S corp.
Setup and Maintenance Expenses
Since it’s a more complex business structure compared to partnerships and sole proprietorships, be prepared to pay more money for the initial setup and higher maintenance fees as your business continues to grow. For instance, you’ll need to file articles of incorporation when you’re forming the S corp and pay the starting fees. Additionally, you might need legal help or an advisor, which are further expenses you need to take into account. In some cases, hiring a registered agent is also required.
When it comes to the ongoing fees you’ll need to pay, they amount to filing annual reports and paying the necessary tax fees. While these fees might not look very expensive, they’re significantly higher than those of sole proprietorships and partnerships.
Since S corps are allowed to have only one class of stock, there is only one class of investors. Some potential investors might be turned off by this. With that said, differences in voting rights are allowed.
Another limiting aspect of S corps is its limit on how many shareholders it can have. For most states, the upper limit of the number of shareholders is 100. Additionally, you’re not allowed to have foreign owners, which could potentially limit your growth and prospects.
Unsurprisingly for a corporation, there are more formalities you need to follow through with than if you were to form a partnership or an LLC. While this can be quite time-consuming, you can always delegate the formalities-related tasks among the owners.
Requirements for a Salary
The IRS requires the owners of S corps to make a salary regardless of the number of profits made in the corporation. This means that you’ll have to distribute salaries even at the start of your corporation when the budget is tight and the profits are low. This turns off many entrepreneurs, which isn’t surprising considering the fact that some businesses take a long time to generate profit.
What Is the Difference Between an S Corp and a C Corp?
If you’re looking to explore different business entities, you might’ve come across C corporations. Both C and S corporations are a type of corporation, but there is a slight difference in terms of how they operate. Both C corps and S corps quality for limited liability. In other words, in case of a lawsuit or a claim, the owners/shareholders won’t be responsible for the company and their assets will remain off limits. While the structure of C corps and S corps remains the same (both types of corporations have a board of directors and shareholders), they differ in terms of taxation.
S corps quality for pass-through taxation, meaning that the owners don’t have to pay double taxation for their income. Instead, every owner is responsible for themselves and pays individual rates based on their personal income.
What Is the Difference Between an S Corp and an LLC?
Considering whether an S corp or an LLC is a better option for you? Here are some of the things these business structures have in common, and some of the ways in which they differ.
The biggest characteristic LLCs and S corps share is that they both offer limited liability to their owners. In case something occurs with the corporation, the owners won’t have to give up any personal assets, which is a huge advantage considering the fragile nature of some businesses.
Another characteristic they share is pass-through taxation. Both LLCs and S corps qualify for pass-through taxation, meaning they don’t have to pay taxes on a corporate level.
Where they differ is in terms of their structure. For instance, S corps have more formalities that need to be followed through with, in addition to being subject to more IRS regulations. Moreover, LLCs have fewer restrictions in terms of how many shareholders they can have and where the owners come from.
All in all, if you’d like to have more flexibility with your business and you’re thinking of expanding your business beyond the U.S., then forming an LLC might be a better option.
How to Form an S Corp
If you’ve considered all the benefits and drawbacks of forming an S corp and you’ve decided that this is the right business structure for you, here are some of the steps you’ll need to take to form one.
File Articles of Incorporation
The first step to forming an S corp is filing the necessary articles of incorporation in order for your business to be incorporated. This step includes paying all the necessary starting fees and taxes for your business to start operating. The articles of incorporation differ from state to state, so make sure you check with the state where you’re planning on conducting your business.
Choose a Name
The second crucial step of forming an S corp is choosing a name for your business. The name you choose must be completely unique. To ensure that your name isn’t taken, you can always conduct a trademark search. In addition, keep in mind that each state has a list of words that you can’t add to the name, so do your research beforehand to make sure these words aren’t included in your name.
After you have the name, it’s time to register with your state’s business formation agency. This step might require you to hire a registered agent or a consultant, which amounts to additional fees.
Obtain a Federal Tax ID Number
The next step is to obtain an Employer ID Number for your business. To complete this step, you’ll need to apply on the IRS website.
Create a Shareholder Agreement
You’ll also want to create a shareholder agreement where you lay out all the bylaws of your business and decide on the ownership transfer in case of an unfortunate event.
Hold an Organizational Meeting
Apart from creating a shareholder agreement, you should hold an initial meeting of the directorial board to complete the bylaws and delegate the responsibilities of each member.
Once your business has been approved by the board of directors, you can start issuing stock to the investors.
If you want to learn about all the intricacies of forming an S corp, we suggest taking a look at the IRS guidelines.
Do S Corps Have Any Special Requirements?
Yes, there are certain requirements you need to meet if you want to form an S corp. For instance, you’re not allowed to have more than 100 shareholders at a time. Additionally, you can’t have members who are not from the U.S.
Plus, there are some restrictions in terms of what kind of stock you can issue, so consider all of these before making a decision.
What Is the Tax Rate for S Corps?
S corps aren’t obliged to pay corporate taxes, but rather the owners are required to pay personal income tax based on the company’s net profits.
Why Should You Choose an S Corp?
There are many different reasons why you’d want to choose an S corp as your business structure. Some of the main benefits that come with forming an S corp include having limited liability as a member and having pass-through taxation.
Is an S Corp an LLC?
While S corps share many similarities to LLCs (Limited Liability Companies), ultimately, they’re a completely different business structure. For instance, they differ in terms of structure – S corps have to comply with more restrictions in terms of members and stock.
We hope you found our article on what is an S corp helpful and that it helped you get a better idea about whether your business would be suited with this type of structure.
Just like with any other business entity, forming an S corp comes with a lot of potential benefits and drawbacks. The biggest thing to consider is whether having a limited number of shareholders would be a problem for you, as well as whether you’d like to have foreign members. If not, then forming an S corp is probably the right decision for you.