What is an S-Corporation?
An S-Corporation is a common entity type for businesses because incorporating your business allows for more protection of assets, and can avoid double taxation on the personal and corporate level.
IRS Definitions of an S-Corp: A corporation is a person or group of people who establish a legal entity by filing articles of incorporation with the state’s secretary of state granting it certain legal powers, rights, privileges, and liabilities. An S corporation is an eligible domestic corporation that wants to avoid double taxation (once to the shareholders and again to the corporation) by electing this status using Form 2553 (Election by a Small Business Corporation).
Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. An S corporation is not a sole proprietor or partnership.
There are requirements for establishing an S-Corp, or electing to be taxed as an S-corp, including being a domestic company, and having less than 100 shareholders.
Requirements & Taxation of an S-Corporation
S-Corporations is taxed by the federal government with “Pass Through Taxation”, like LLCs, Sole Proprietorships, and Partnerships, but NOT like Corporations or C-Corporations. This means that the federal tax on profits and losses of the S-Corp are passed to the shareholders’ of the S-corps personal IRS tax returns. This is a key difference between S-Corps versus a general corporation.
The biggest benefit of S-corp taxation, unlike Sole Proprietorships and partnerships, there is no self-employment tax on the shares of the business profits. But, there are additional tax requirements of S-Corporations:
- Each owner who works as an employee of the business is required to be paid a salary, and the salary is subject to taxes (Medicare, Social Security, and Unemployment). These taxes are paid half by the corporation itself, and half by the employee/owner.
- State Taxation: Every state has their own rules of taxation for an S corp.
Corporations must meet certain criteria to form an S-Corp and file form 2553. LLCs must also meet these requirements when electing to be an LLC taxed as an S-Corp
- It must be a domestic company (not foreign)
- It must have no more than 100 shareholders/members
- The shareholders can be individuals, estates, or tax-exempt organization (non-profit organizations), and CANNOT be Corporations or Partnerships.
- Shareholders cannot be nonresident aliens of the United States of America.
- There can be only 1 class of stock
- A Bank or Insurance company are not allowed to form S-Corporations
- All shareholders must content to form an S-Corp
S-Corporations file Form 1120-S for their annual federal income tax return to the IRS, whereas regular corporations file Form 1120. Like Partnerships, S-Corporations use forms Schedule K and K-1 to report income, deductions, and allocation of assets among the members.
Also like partnerships, members of an S-Corp are taxed on their share of the income, whether or not the income of the business was actually distributed to the individual.