What Is an S corporation? Whether you’re self-employed or seeking information to form a company, you have to decide how to organize it.
There are a lot of different business structures, each with different approaches to liability and governance. To learn more about other business structures, check out our comparison page. If you have one in mind but are intimidated by the process, take a look at all the services ZenBusiness offers that can help you.
Most business entities like corporations are distinct legal entities, existing separately from their owners and operators. This includes how the company is taxed. One of the more commonly misunderstood federal taxation schemes is the S corp. In this guide, we’ll provide an overview of what an S corporation is, how it’s taxed, and how this designation can affect your business. Let’s take a closer look at the Subchapter S corporation, known as an S corp.
Choosing between S corporation and C corporation
You may have heard references to C corporations and S corporations, but are not quite sure what their differences are, or even if there are any. First off, S corps and C corps aren’t specific entity types, but tax classifications defined and approved by the Internal Revenue Service (IRS). The primary difference between the two is how each pays federal income taxes.
- Income from C corps is taxed at both corporate and personal levels, creating “double taxation.”
- An S corp election is popular for smaller businesses because corporate income isn’t taxed until after distributing to shareholders, referred to as a pass-through entity.
When you apply for an Employer Identification Number (EIN), the IRS automatically classifies your business entity based on what the entity’s type and size is.
The IRS’s default classification for all corporations is C corp, and it will stay that way unless you specifically file the correct form to change your tax status. However, if you think an S corp is a better tax structure for your business, get ready to dive into some paperwork. Corporations already have strict tax reporting and compliance requirements, and an S corp election means more of the same.
Finally, it is important to note that the IRS may tax S and C corporations differently, but on a state level both are formed and referred to simply as corporations.
If this is making your head spin, we have good news. ZenBusiness offers convenient solutions to help you form your business entity, as well as sesrvices to help you stay compliant with state laws.
How does an S corporation classification work?
Upon formation and registration with the IRS, your business is given a default tax classification. For corporations this means a C corp classification, for LLCs either a partnership classification or a disregarded entity (sole proprietorship). For those who formed their business as a corporation, it will be considered a C corp until you file Form 2553 asking the IRS for a status change to an S corporation.
To qualify for S corporation status, the requirements are:
- Only one class of stock can be issued.
- Shareholders are limited to 100.
- Shareholders must be U.S. residents, estates, trusts, and tax-exempt organizations.
- Must be a domestic business entity.
S corps are treated as pass-through entities, meaning the corporation’s income is taxed only at the shareholder level. The shareholders pay taxes at their personal income rate.
This doesn’t mean the corporation is entirely off the hook — S corps must file IRS Form 1120S: U.S. Income Tax Return for an S Corporation and possibly state tax forms as well; not all states recognize the S corp status for state income taxes. Although S corps may not pay federal income taxes on corporate profits, they may be subject to taxation from built-in gains and passive income.
Can an LLC choose S corporation taxation?
The limited liability company (LLC) is one of the newest and most popular business entity forms in many states. Unlike S corp classification, the LLC refers to the business structure itself, which can be taxed in a number of different ways. With an S corp election, the LLC’s profits and losses flow through the entity to its members, who pay personal income tax on earnings.
LLCs and S Corps: Organization and Ownership
An LLC is easier to form, and gives more flexibility with ownership than corporations. The LLC’s owners — known as members — may be individuals, corporations, and foreign entities. In a corporation, ownership rights are divided amongst its shareholders.
Forming an LLC is not as involved as incorporation is. The flexibility and control this entity gives its members combined with personal liability protections is why the LLC is the most popular entity type in most states.
However, transferring ownership in corporations is easier than in LLCs. Shares in a corporation can be sold to any eligible investor, although this is subject to potential limitations in the bylaws or shareholder agreements. In an LLC, the process is much more involved.
S Corp Taxation and LLCs: Why?
Unlike corporations, the default tax classification for LLCs can differ based on the number of members. If the LLC is a single-member entity, the IRS will treat it as a disregarded entity, and you will pay taxes using your own social security number as a sole proprietor. If there are two or more members on formation, the IRS classifies it as a partnership for taxation purposes. Just like with a standard corporation, an LLC must actively apply for S corp designation. So why would an LLC want to choose an S corp election?
In some situations, businesses may have state law reasons for wanting their business to be formed as an LLC, but for tax purposes they would prefer S corp election over a partnership classification.
For example, an LLC member might be subject to self-employment tax on their share of the company’s income under the partnership scheme, while in an S corp scheme the members will be able to avoid the tax.
Pros and cons of an S corp designation
We’ve covered a lot of information — let’s do a quick summary of an S corporation’s advantages vs. disadvantages before moving on.
- Shareholders’ assets are considered separate from the corporation.
- There’s a flexible ownership structure because shares can be sold without affecting the corporate entity.
- Income, deductions, and credits can be passed on to shareholders for taxation at a personal rate.
- Corporations must meet many legal and reporting requirements, which can be costly to set up and maintain.
- There are restrictions on the type of stock issued and who or what can hold them.
How to form a corporation or LLC
Before you can choose an S corp designation, you must incorporate or form your business at the state level first. Every state is different, but this is the information you’ll likely need, no matter which state you live in.
1. Choose your business name
Most LLCs or corporations must include a corporate identifier in their names, such as Corporation (Corp.), Incorporated (Inc.), LLC, etc. The allowed identifiers will sometimes vary by state. Some businesses also choose a Doing Business As (DBA) name they use as a trade name. This is to notify the public in cases where the trade name differs from its legal name.
When choosing a name, you must check to make sure the name is available. You can look up whether a name is available on the state’s Secretary of State website in most states. If the name is taken, the state may reject your filing. If you’ve settled on a name for your business but aren’t ready to officially register it with your state, consider reserving the name, so it’s available later. And because an online presence is essential these days, you should also secure a domain name for your website. ZenBusiness has great insights to offer your company along with convenient solutions.
2. Choose a registered agent
Corporations and LLCs must have a registered agent, sometimes known as an agent for service of process, to receive legal notices and correspondence from the state agency overseeing business formation. The registered agent must be available at a physical location within the filing state that’s open during regular business hours throughout the year. ZenBusiness helps business owners fulfill their requirements for a registered agent.
3. File formation documents
For your business to be legally recognized, you must file Articles of Incorporation, Articles of Formation, or whatever form is necessary for your state. Check with your state agency for detailed instructions. Required information typically includes:
- A business name
- A registered agent’s name and address
- A business address
- The name, address, and signature of the members (LLC) or board of directors (corporation)
Remember — even when your formation document is approved, it isn’t officially recognized as an S corporation for tax purposes. You must file a form with the IRS.
4. Draft and adopt corporate bylaws or an operating agreement
Corporate bylaws and operating agreements (LLC) are the rules that guide the operation of your business. All corporations and LLCs should have bylaws or an operating agreement, even if the state does not legally require it, to ensure proper governance. Learn more about operating agreements and corporate bylaws and how ZenBusiness can help.
5. File for business permits and licenses
Once your business structure is in place, you need to acquire the right business permits and licenses on federal, local, and state levels. Some states and localities also require a general business license to conduct business at all.
Given all this, it can be difficult to determine exactly what licenses and permits you need to operate legally, given there’s no one-stop location to check for all of them. To make sure you’re up to date and have all the proper licenses and permits, use our business license report service.
6. Get your Employer Identification Number
Now it’s time to get your Employer Identification Number (EIN), which the IRS uses to identify your corporation.
You need an EIN for tasks such as opening a corporate bank account, paying income taxes, and hiring staff. These should be completed under the umbrella of your corporation to keep everything separate from the owners.
You can secure an EIN online, and ZenBusiness makes the process simple.
File for S corp tax status
Congratulations! Once you’ve got your EIN, you’re ready to take the final step to designate your company as an S corp. Remember, the IRS considers your corporation a C corp unless you complete and file Form 2553, Election by a Small Business Corporation.
To complete this form, you need the consent of all shareholders or LLC members. It can be submitted in the tax year preceding the year it takes effect or up to two months and 15 days into that tax year. The IRS should let you know within 60 days if the status change is approved.
Need more information to start your business?
In this overview, you’ve learned that there’s a lot of paperwork and compliance required when starting an S corporation. ZenBusiness can make forming your corporation stress-free, so you can devote time to building a thriving business. Contact a ZenBusiness expert today to learn how our solutions can get your corporation off to the best possible start.
S Corp FAQs
What does the S in S corp stand for?
The S stands for Subchapter S. This is the section of the Internal Revenue Code that governs S corporations. More specifically, it’s Chapter 1, Subchapter S — Tax Treatment of S Corporations and Their Shareholders.
Can I change from an LLC to an S corp?
Yes, your company will still remain an LLC, but it can be taxed as an S corp. To request that the IRS taxes your LLC income as an S corporation return, you need to complete two forms. First, complete Form 8832, Entity Classification Election, which asks the IRS to classify your business as a corporation for federal tax information. Then, file Form 2553, Election by a Small Business Corporation, to be treated as an S corp instead of an LLC.
Can I change from a C corp to an S corp?
If you decide to change to an S corp, you need to file form 2553, Election by a Small Business Corporation, with the IRS. The instructions for the form are on the IRS website. The form must be signed by a corporate officer with the written consent of all shareholders. Once this is approved by the IRS, you must file your last C corp tax return by the due date. The IRS finalizes the change once it receives your first S corp tax return.
Can an S corp have a single owner?
Yes. An S corp must issue a minimum of one share, so there may be one owner.
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