Most of us have an idea of what a corporation is. Typically, we think of big businesses like Target, Walmart, or Amazon. However, not every corporation is as huge as those we just named.
In fact, there are a number of companies that are technically corporations but are a lot smaller than a business such as Amazon. The S corporation is a type of corporation that is limited in its size. It functions similarly to other corporations but is different when it comes to its number of shareholders and how it is taxed.
Today, we’re going to share important information about S corporations. Whether you’re looking to set up a corp yourself or just want to learn more, you’ll have a much better understanding of S corps by the end of this article.
We’ll explain exactly what an S corporation is, how it is taxed, how it is formed, and how it is different from other types of business structures, including other corporations. We’ll also share the advantages and disadvantages of S corps so that you can easily see the pros and cons of owning an S corporation.
What Is an S Corporation?
S corporations, also known as S subchapters, follow the same structure as any other corporation. That is, they are owned by shareholders who elect a board of directors to oversee the company.
The owners of S corporations also enjoy limited liability, which means their personal assets are not at risk should the company face debts. Corporations, including S corps, are legally recognized as a single entity like a person and, as such, can take out loans, sue and be sued, and must pay taxes.
S corps differ from other types of corporations when it comes to the number of shareholders they can have, which is no more than 100. That’s why forming an S corporation can be a good choice for a small business but wouldn’t necessarily be a great choice for a larger company seeking unlimited growth potential.
Furthermore, the shareholders of S corporations must be U.S. residents and cannot be business entities like other corporations or LLCs. What sets S corps apart the most from other corporations is the way they are taxed. In fact, S corporations got their name because they are taxed under the IRS Subchapter S.
How Are S Corps Taxed?
Since taxation is an important part of an S corp’s identity, let’s talk about it more in detail. S corporations do not pay taxes at a corporate level. Instead, shareholders report losses, gains, and deductions on their personal taxes. This allows the company to pay less taxes since personal tax rates are lower than corporate tax rates.
Not only that, but this also means S corporations are not subject to double taxation as other corporations are. Double taxation happens when profits are taxed at a corporate level and then again at a personal level after they are dispersed to shareholders.
Shareholders of S corporations can also take advantage of tax-free dividends. These dividends cannot exceed a shareholder’s stock basis, or they will be taxed as capital gains. However, even then, the tax is lower than income taxes. As long as the dividends don’t exceed the shareholder’s stock basis, they are tax-free.
Shareholders can even increase the amount of tax-free income they receive. While the IRS still expects S corps to set salaries at a reasonable amount, salaries are usually set as low as they can without getting the S corp into trouble. Lower salaries mean less money is taken from the salary through taxes.
Shareholders of S corps can and often are employees and are obviously there to make money. Though the tactic of lowering salaries doesn’t seem beneficial, it is made up for by the tax-free dividends. S corps set salaries low in order to pay less in taxes because they can disburse money through tax-free dividends.
Though S corps have a pretty sweet deal in regard to how their profits are taxed, they do have to pay employment taxes just like everyone else.
How Are S Corporations Formed?
The process of forming an S corporation is like that of forming any other type of corporation, but with an extra step. To become an S corp, a company must first become incorporated.
The process of incorporation varies across states since the company must follow the laws of the state it resides in. However, incorporation typically involves filing articles of incorporation.
Again, the information required for the articles of incorporation will vary by state. However, the articles of incorporation usually include the corporation’s name, the contact information of the corp’s registered agent, the contact information of the initial board of directors, the number and type of authorized shares, and the name, signature, and address of the person in charge of setting up the corporation.
Upon formation, corporations also create bylaws. These bylaws outline how the company will be run. They set terms of office, outline the board of directors’ responsibilities, and state how often the board of directors should have meetings.
Once the company is incorporated, it must file IRS form 2553. This form designates the corporation as an S corp and is necessary for the company to be taxed as an S corp. All shareholders must sign the form for it to be accepted by the IRS.
How Are S Corps Different From Other Corporations?
To help you better understand what an S corporation is, let’s talk about how it differs from other business structures, especially corporations.
C corporations are the most common type of corporation in the U.S. They’re similar to S corps since they both follow the same corporate structure of being owned by shareholders and managed by a board of directors.
However, C corps are not limited in the number of shareholders they can have. As such, they have unlimited growth potential through the creation and sale of stocks. Shareholders of C corps also do not have to be individuals; they can be entities like other corporations or LLCs.
Finally, the way C corporations are taxed is vastly different from S corps. C corps are charged a corporate tax on all their profits which get taxed again when they are reported on an individual shareholder’s taxes. This is called double taxation.
Benefit corporations are also known as B corps; since they are corporations, they also follow the same structure of being owned by shareholders and run by a board of directors. These corporations are unique in that their mission is to be beneficial to the world in some way.
According to Business Insider, B corporations “strive to reduce inequality, lower poverty levels, and create a healthier environment, stronger communities, and purposeful jobs.” Though B corps may seem charitable, they are still for-profit companies. Essentially, they hope to provide some meaningful benefit to the environment or the community while still making bank.
B corps tend to take accountability for their practices and be more transparent than other types of corporations. Their goal is to generate both money and positive change.
Generally, B corps are taxed the same as C corps. However, they can opt to be taxed as S corporations.
You can probably guess what a nonprofit corporation is. Nonprofit corporations follow the same structure as any other corporation, but their profits are not used for personal gain. Instead, profits go into keeping the company running and towards charitable efforts.
Though nonprofit corporations have a board of directors that manages the direction of the organization, they do not have shareholders. This is because the shareholder position typically receives profits made by the company. Since nonprofits are using their revenue for charity, there is no place for shareholders in a nonprofit corporation.
Another important difference between nonprofits and S corporations is that nonprofits can avoid paying certain taxes. For example, they have to pay employment taxes for anyone on the payroll, but they aren’t subject to paying corporate income taxes. Nonprofits typically do not have to pay property taxes or sales taxes, either.
Limited Liability Companies are not corporations, but we still feel it is useful to compare them to S corps. This is because LLCs can opt to be taxed in the exact same way as S corps, so if you’re still trying to figure out the best structure for your business and are considering an S corp, it may also be worth considering an LLC.
LLCs are quite different from S corporations. Instead of being managed by a board of directors, they are run by their owners. There is no limit to the number of people who can be owners of an LLC. These owners are not shareholders, though; they are all members of the LLC and receive profits dependent on their stake in the company.
LLCs are also much easier to form than corporations and require a lot less paperwork. Despite this, they offer the same limited liability protection as S corps.
Even if an LLC does not opt to be taxed like an S corp, the way it is taxed is a bit similar. Just like an S corp, profits are reported on personal income taxes. However, those working for an LLC are considered self-employed and thus have to pay self-employment taxes.
Shareholders of an S corporation typically do not have to pay self-employment taxes. In the event that they would, they typically save on self-employment taxes thanks to the tax-free distributions we explained earlier.
Advantages and Disadvantages of S Corporations
Now that you have a deeper understanding of S corporations let’s review their advantages and disadvantages.
- Shareholders’ personal assets are protected by limited liability
- S corps are not double-taxed or taxed at the corporate level
- S corps can reduce salaries (within reason) to pay less in taxes
- Reducing salaries allows for greater profits through tax-free distributions
- S corporations cannot have more than 100 shareholders
- Shareholders cannot be other corporate entities or foreigners
- S corps do not have unlimited growth potential
- S corps are strictly scrutinized by the IRS to ensure the corporation meets the requirements to be taxed as an S corp
S Corps: Smaller Business, Smaller Taxes
S corporations are quite different from C corporations. Though they follow the same general structure, and both enjoy limited liability, S corporations are not taxed as heavily.
S corporations are also not double taxed; in fact, their dividends are often tax-free or, at the very least, have a relatively low tax rate. However, in order to be taxed in such a way, S corps have to meet certain requirements.
For instance, they cannot have more than 100 shareholders. This means S corps do not have the same growth potential as C corps. S corps must also pay their employees a reasonable salary.
This is important because one of the ways shareholders of S corps make money is by reducing their salaries and receiving payouts via dividends. The lower their salaries, the less money shareholders must pay in income taxes.
Because of this, the IRS may heavily scrutinize S corps. The IRS needs to make sure it’s still getting a fair amount of income taxes from S corps, so it can’t allow them to set salaries lower than what would be considered average for each position in the company. S corps that don’t follow these rules can lose their status and the tax benefits they’re receiving.
Like any other type of business structure, there are advantages and disadvantages to S corp status. However, S corporations are often a great option for smaller businesses due to the tax benefits.