What is a S Corporation? The Complete Guide to Forming and Operating a S Corp Business

Starting a business involves making many important decisions. One of the first steps is choosing the right business structure. S corporations, or S corps, are popular for small and medium-sized businesses in the United States. But what exactly is a S corp, and how does it work?

In this comprehensive guide, we’ll explain everything you need to know about S corps, including:

• What is a S corporation?
• S corp benefits and drawbacks
• S corp requirements
• How to form a S corporation

What is a S Corporation?

A S corporation, or S corp, is a legal business structure that combines the limited liability of a corporation with the tax benefits of a partnership or sole proprietorship.

Here’s a quick overview:

• S corps are incorporated at the state level, like C corporations. It gives S corps limited liability protection.
• But for federal income tax purposes, S corps can “pass-through” income to shareholders. It avoids the “double taxation” issue faced by the C corps.
• S corps have strict eligibility requirements related to the number of shareholders, shareholder types, classes of stock, etc.
• S corps require more administration than sole proprietorships or partnerships but less than C corps.

So, in essence, S corporations give small businesses the liability protection of a corporation with the tax flexibility of a partnership. This unique combo makes S corps popular for many small business owners.

Now, let’s look at the benefits and drawbacks of S corps in more detail.

S Corporation Benefits

Pass-through taxation – It is the #1 reason most small businesses choose the S corp structure. S corps avoid double taxation by passing income directly to shareholders to report on their personal returns. It saves a ton on taxes compared to the C Corps.

Limited liability – S corps protects owners from business debts and liabilities as a separately incorporated entity. Creditors can’t go after your assets like they could in a sole proprietorship or partnership.

Flexible shareholder compensation – S corps gives owners flexibility in paying themselves. You can take distributions, wages, or both, providing tax optimization opportunities.

Raising capital – S corps can issue stock to bring on investors and raise capital. It isn’t as easy with LLCs or partnerships.

Business credibility – Being incorporated gives your business more credibility in the eyes of customers, partners, and lenders. The corporate structure projects stability.

No special tax forms – S corps use the same Form 1120S tax return as other corporations. You don’t need to file special partnership returns like with LLCs.

Easy conversion – Existing LLCs and C corps can easily convert to S corp status by filing Form 2553 with the IRS. No need to dissolve and re-form the business.

S Corporation Drawbacks

Strict eligibility requirements – S corps has a long list of formation and operational requirements related to ownership structure, stock classes, subsidiary businesses, etc.

Added administration – S corps requires corporate formalities like adopting bylaws, holding director/shareholder meetings, filing annual reports, and keeping minutes. This administrative burden is higher than with LLCs.

Self-employment taxes – S corp income is subject to full self-employment taxes, unlike LLCs where you can take a reasonable salary. It can mean higher taxes for some owners.

One class of stock – All S corp shareholders must hold the same class of stock with equal rights. Preferences or special allocations among shareholders are prohibited.

Shareholder restrictions – S corps can only have up to 100 shareholders, and all must be US citizens or residents. It makes S corps inaccessible to many investors.

Limited fringe benefits – Only 2% of S corp shareholders can take advantage of fringe benefits like health insurance premium deductions.

Termination risk – Violating one of the many S corp requirements can lead to involuntary termination of S corp status and a transition back to C corp taxation.

As you can see, S corps offers some great perks but also has limitations and drawbacks. Make sure you weigh both sides before choosing the S-corp structure.

S Corporation Requirements

To qualify for S corp status, a business must meet specific IRS requirements related to formation, ownership structure, stock classes, etc. Here are the key S corp eligibility rules:

Must be a domestic corporation formed in the United States

• Have 100 or fewer shareholders
• Have only eligible shareholders who are individuals, estates, exempt organizations, or certain trusts
• Have only one class of stock issued
• Cannot have nonresident alien shareholders
• It cannot be an insurance company or a certain financial institution

In addition, S corps must follow certain operational requirements to maintain their special tax status:

• Shareholders must be paid reasonable compensation for services rendered.
• Must file Form 1120S to report shareholder income, deductions, losses, etc.
• Must file Form 2553 to elect S corp status
• Cannot own 80% or more of a C corporation subsidiary

Violating any of the S corp eligibility rules can lead to involuntary termination by the IRS and a switch back to standard C corp taxation. So it’s critical to stay compliant if you want those sweet S corp tax benefits!

How to Form a S Corporation in 11 Steps

Follow these key steps to establish your business as a S corporation properly:

Choose a Business Name

• Research availability and register your chosen name with the state
• Include a corporate designation like “Inc.” or “Corp.”

Appoint Directors and Officers

• Appoint initial board members to oversee high-level policies
• Elect officers like the President, Secretary, and Treasurer to manage daily operations.

File Articles of Incorporation

• Draft articles establishing your corporation as a legal entity
• File articles with your Secretary of State’s office

Create Corporate Bylaws

• Outline operating rules like shareholder meetings, voting, etc.
• Formally adopt bylaws at the first board meeting.

Issue Stock

• Document stock distribution to initial shareholders
• Outline classes of stock, voting rights, dividends, etc.

Hold Organizational Meeting

• Elect directors, approve bylaws, authorize stock issuance
• Document meeting minutes showing formal corporate actions

Obtain EIN from the IRS

• Acquire federal EIN to open bank accounts, pay taxes
• Apply online via the IRS website

File S Corp Election with IRS (Form 2553)

• Submit within two months and 15 days of the intended S corp status date.
• All shareholders must consent to the S corp election.

Follow State Formalities

• Register to do business in states where operating
• File annual reports to maintain incorporation

Issue Stock Certificates

• Formal certificates documenting percentage ownership
• Signed by an authorized officer like the President or Secretary

Maintain Corporate Records

• Keep minutes, bylaws, and stock ledgers to document actions
• Store records at the registered office

These key steps will ensure you establish and maintain your S corporation status properly. Let me know if you need any clarification or have additional questions!

Frequently Asked Questions:

The Bottom Line on S Corps

S corporations offer a compelling middle ground between sole proprietorships’ simplicity and full C corporations’ liability protection. The pass-through taxation of S corps also provides significant tax savings for many small business owners.

However, the eligibility requirements, ownership restrictions, and administrative formalities make S corps more complex than LLCs. You’ll need to weigh whether the S corp structure is worth the trade-off for your specific business situation.

Key factors to consider include:

Your projected income level and tax bracket

• Desired liability protection
• Need to raise outside investment
• Number of owners involved
• State tax treatment of S corps vs. LLCs

Consult with legal, tax, and financial advisors to determine if S corp status makes sense for your business. Carefully evaluate both the advantages and disadvantages before incorporating.

With the right preparation and planning, an S corp can provide an optimal structure for launching and growing a successful small business. Take the time to make an informed decision before filing those S corp election forms.

I hope this comprehensive guide has provided clarity on what S corps are all about. Let me know if you have any other questions!