What is an S corporation?
UPDATED: February 7, 2020
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When any corporation is formed, two main sets of laws will determine which type of structure is best to use. Federal laws cover federal tax issues and consequences; while state laws establish rules regarding structure and incorporation procedures. How and where an organization is incorporated will affect the tax rules that apply to the organization. It will also influence the amount of protection, advantages, and disadvantages for shareholders. A Sub S or S corporation, is one of the types of corporations created through this overlap. The "Sub S" part of the name comes from the federal law regarding the taxation of this type of corporation, which is “Subchapter S” of Chapter 1 of the Internal Revenue Code.
Understanding Sub S Corporations
A Sub S Corporation is a regular corporation that opts to tax its profits at the personal income tax level. An S corporation must prepare and file an income tax return, but itself pays no tax (if it complies with all of the technical and complex rules of federal laws). Each shareholder pays taxes on his or her share of S corporate income on his or her individual tax return. Owner-employees of an S corporation are treated like partners for purposes of employment and benefits.
How to Establish an S Corp
The process of setting up an S corp is the same as with a regular corporation. The state in which you incorporate will have its own set of rules regarding how to incorporate including where to file, filing fees, articles of incorporation, and the designation of registered agents to receive service. As you are making decisions regarding state incorporation, you should also make sure that you follow the over-lapping federal Subchapter S rules. For example, shareholders must be U.S. citizens and the S corp can have no more than 100 shareholders. Non-compliance with federal laws can result in the corporation falling out of status, which means the corporation will still exist, but the IRS will begin taxing the corporation like a regular corporation.
The final step in setting up an S corp involves getting final approval from the IRS and the incorporating state, if required by that state.
Advantages and Disadvantages of Incorporating as a Sub S Corporation
Many people incorporate their businesses as Subchapter S corporations for liability protection. Even though the shareholder is taxed like a partner, their personal liability for any legal issues is limited. Other advantages include: losses can be passed on to investors, two levels of taxation are avoided, and no accumulated earnings tax. Essentially, an S corp combines the tax advantages of a partnership with the liability protection of a regular corporation.
Despite its advantages, an S corporation can have drawbacks. For example, Sub S rules limit the number of shareholders. An S corp can only have one class of stock and must operate under a group of specific rules, like not being able to bring the S corp forward in a public offering to raise capital. Other drawbacks include: at-risk limitation, basis limitation on losses, passive loss limitations, and investment interest limitations. Some drawbacks may be specific to the state in which it functions: states have their own tax rules, which may or may not outweigh the benefits of a S corporation.
If you own a business and are considering incorporation as an option for liability protection, consult with a business attorney or tax attorney in your state that regularly handles incorporation and corporate tax issues. Many online services now offer do-it-yourself kits for incorporating. Incorporating without the assistance of an attorney can result in missed filing deadlines for federal or state tax issues, which can be very expensive. Proper pre-planning and professional assistance with establishing an S corp provides the best protection for your business.