What is an S-Corp?
An S corporation (also known as S-Corp or S subchapter), is an IRS classification that converts a business into a pass-through entity for tax purposes, avoiding double taxation. S-Corps pass income, losses, deductions, and credits to shareholders, who report everything on their personal tax returns. This distinguishes S-Corps from C-Corps, where income is taxed at the corporate level and—where dividends are distributed—at the personal level too.
How to Create an S-Corp
No business starts life as an S-Corp. Rather, shareholders organize as a C-Corp (the default type of corporation) or LLC and elect S corporation status using IRS form 2553. You have 75 days after the start of a new tax year to elect S-Corp status for that tax year.
To qualify for S-Corp status, your business must meet the following requirements:
Be a domestic corporation or LLC
Have no more than 100 shareholders (shareholders may be US citizen or resident alien individuals, certain trusts, or estates)
Have only one class of stock
The following businesses cannot be considered for S-Corp status:
Corporations with shareholders that are non-resident aliens, partnerships, or corporations
Ineligible corporations, i.e. certain financial institutions, insurance companies, and domestic international sales corporations
Pros and Cons of Converting to an S-Corp
Like all issues of taxation, the consequences of converting to an S-Corp are highly complex and depend very much on individual preferences and circumstances. As always, we recommend consulting a certified tax advisor before making a decision.
The best-known advantages of converting to an S-Corp are:
No double taxation.
In a C-Corp, the business pays corporate tax on all profits and the shareholders pay tax on dividends. In an S-Corp (and LLC), there is no corporate tax; all profits flow through to the individual shareholders and are only taxed on a personal income basis.
Lower self-employment tax.
In an LLC, the owners must pay self-employment tax (Social Security, currently 12.4%, and Medicare, currently 2.9%). In an S-Corp, a shareholder can be treated as both an owner and employee. The money you make as an employee (i.e. your salary) is subject to self-employment taxes but the money you make as a shareholder (i.e. dividends) is exempt from those taxes. The catch here is that your salary must be ‘reasonable’ (in the eyes of IRS auditors), meaning it must match up with the amount of experience, time, and energy you bring to the business.
Offsetting losses.
If the S-Corp loses money, these losses pass through to the shareholders, who can use the losses to offset tax liabilities from other income.
Less reporting.
Under IRS rules, an S-Corp is only required to file an annual report, whereas a C-Corp must file a quarterly tax estimate.
The best-known disadvantages of converting to an S-Corp are:
Limits your funding options.
Because an S-Corp is limited to 100 shareholders, none of which can be another corporation, this makes it harder to raise venture capital or any other type of funding that involves giving the investor an equity stake.
You may have to pay state corporate tax.
S-Corp is an IRS designation that grants a corporation pass-through status at a federal level. Most, but not all, jurisdictions acknowledge S-Corp status. Some, including Louisiana, New Hampshire, Tennessee, New York City (but not the rest of New York state), and the District of Columbia, treat S-Corps like C-Corps, subjecting them to corporate tax on profits. Others, including California and Texas, subject S-Corps to franchise tax, a small levy on net worth that is imposed even when a corporation makes a loss.
More IRS scrutiny.
Because income can be distributed to shareholders as salary or dividends, the IRS scrutinizes payments to make sure they fit its definition of reasonability. In some cases, the IRS may redefine dividends as salary, subjecting your S-Corp to additional employment tax.
Less flexibility.
The IRS rules governing S-Corp status stay with you for as long as your business exists. Violate any of the rules (e.g. add a 101st shareholder or issue a second class of stock) and you risk losing your S-Corp status.
How Can a Legal Services Provider Help You Establish an S-Corp?
Online legal service providers are really just alternatives to traditional law firms. They can help you do things like form a business entity, create contracts, submit documents—but for a fraction of the price it costs to do the same thing using a traditional lawyer. Legal service providers typically cater to small and medium business owners. This makes them perfect for simple business entities with fewer than 100 shareholders that are considering converting to S-Corp status.
Technically, you can become an S-Corp without any outside help. But if you do it yourself, you’ll need to do all the legwork associated with creating a corporation or LLC (such as filing articles of incorporation, appointing shareholders, issuing stock or membership certificates, and creating corporate bylaws or an operating agreement). Then, after creating your business entity, you’ll have to file IRS form 2553 (and form 8832 if you’re an LLC) to elect S-Corp tax status.
A legal services provider can do all the above for you and do it quickly and cheaply enough that it makes it worthwhile to outsource the work. For about $250-$300, the best legal services providers will do all the legwork of creating your business entity and getting you classified as an S-Corp for taxation purposes.
