The Internal Revenue Service (IRS) defines an S-Corporation as an organization that passes credits, deductions, income, and losses through to shareholders for federal tax filing purposes. The shareholders of S-Corps then report income and losses for the business on their personal tax return.
One of the biggest benefits of forming S-Corps is that it allows companies to avoid double taxation at the corporate level. However, the IRS expects S-Corps to pay tax on certain types of passive income and gains.
Criteria Required to Form an S-Corp
Your company must meet each of the following IRS criteria before it can request classification as an S-Corp:
- Operate as a domestic corporation within the United States.
- Offer only one classification of stock.
- The business has 100 shareholders or less.
- Only allowable shareholders are individuals, estates, and certain types of trusts. This excludes corporations, non-resident aliens, and partnerships from becoming shareholders.
- Domestic sales organizations operating internationally, most financial institutions, and insurance companies cannot hold stock in S-corps.
If your business meets these qualifications and has decided to file for S-Corp status, the next step is to complete IRS Form 2553, called Election by a Small Business Corporation. The form must contain the signature of all shareholders.
S-Corp Pros and Cons
In corporations other than an S-Corp, the IRS taxes income at the corporate level and again at the individual level. This is known as double taxation, which is something that S-Corps can avoid. Here are additional benefits to consider:
- Protection of personal assets: Shareholders bear no personal legal obligation for the debts of S-Corps. Because of this, those attempting to collect a debt cannot seize the personal assets of any of the shareholders.
- Flexibility in the transfer of ownership: With up to 100 shareholders in the typical S-Corp, people frequently leave or come on board. This can make it easier for the current shareholders to plan long-term growth as ownership is not dependent on only one or two individuals. Unlike other business structures, the departure or addition of a shareholder has little effect on management or the ability to sell a business.
- Lower self-employment tax: Shareholder earnings from S-Corps fall into the categories of distribution or salary. The S-Corp structure often lowers the self-employed tax burden while also eliminating double taxation. The reason for this is that shareholders only pay tax on the salary portion of the funds they receive.
Like all big decisions, you also need to consider any potential drawbacks to S-Corps. Some people do not like to work with the many restrictions such as only offering shares to legal citizens of the United States and other limits on who can be a shareholder. Since the allocation of income and losses is based on each shareholder’s ownership percentage, you cannot modify this arrangement later like you could with a limited liability company.
Keep in mind you need to follow strict regulations such as scheduling regular shareholder meetings and maintaining paperwork requirements. While not necessarily a negative when compared to other business structures, you also need to pay income tax and employment tax and may need to make estimated tax payments.
Could you use help deciding the right tax structure for your business? This is just one of many services we offer at Palmetto Payroll. Please contact us to learn more or request an appointment.
