When forming a corporation, there are many factors to be considered, including management, liability, the role of shareholders, and taxation status. For typical corporations, known as C corporations, taxation is a significant issue because the profits of these types of corporations are typically taxed twice: once when the business receives profits, and again when these profits are passed on to shareholders or owners who must report them on their own taxes. The S corporation model was created to allow businesses and their owners an alternative to this double taxation.
An S corporation is a special type of corporation that receives an “S” designation from the IRS. This designation allows the profits of the corporation to “pass through” the business onto the shareholders or owners. Accordingly, the profits are not taxed at the business stage, but they are taxed when declared on the shareholder’s or owner’s taxes. Thus, “S” status allows the business to retain more profits and pay lower taxes.
S corporations are also considered to be “unique entities” from their owners, according to the IRS, and are treated as completely separate from their shareholders. As a result, the shareholders have limited financial liability for the actions or decisions of the S corporation. This does not, however, preclude liability for intentional bad acts.
Forming an S Corporation
Owners interested in designating their business as an S corporation must first file as a standard corporation, including filing articles of incorporation and any other necessary documents required by the state of incorporation. Next, the shareholders of the corporation must agree to elect that the business become an “S corporation.” This is done by filing a tax form called a Form 2553, which informs the IRS that your business wishes to obtain “S” corporation designation. Thus, the process of application is relatively straightforward.
It is important to know, however, that any business wishing to be designated as an S corporation must meet strict requirements. Specifically, all shareholders of an S corporation must be United States citizens. There also can be no more than 100 shareholders of an S corporation. Additionally, profits from an S corporation must be allocated to shareholders in proportion to their ownership interest in the company. This means that a shareholder who owns 10% of an S corporation cannot receive more than 10% of the company’s profits. For businesses or business owners who find it difficult to meet the requirements for S corporation status, perhaps because a shareholder is a foreign citizen, for instance, another appealing alternative for business formation is the limited liability company, which offers many of the same taxation benefits of an S corporation, but without as many restrictions on formation.
Exceptions to the Taxation Benefits of an S Corporation
Before assuming that an S corporation is the best business model for your tax purposes, you should know that several exceptions exist to the limitations on taxation. First, any shareholder who works for the corporation in some capacity is required to receive “reasonable compensation” for his or her efforts, which must be taxed as wages rather than pass-through profits. Second, not all state laws follow the IRS approach to S corporations. Some states, such as New York, continue to tax both the business profits and the shareholder profits of S corporations, thereby reducing the benefits of this status.