S Corps: Everything You Need To Know

What is an S Corp? How do they work? How are S Corps different from an LLC? We're breaking down everything Founders could possibly need to know about S Corps so you can decide if it's right for you.

March 26th, 2019   |    By: The Startups Team    |    Tags: Operations, Legal, C Corp, Patents, S Corp

What is an S Corp?

An S Corporation is a type of business corporation.

An S Corp passes all their finances — corporate income, losses, deductions, and credits — through their shareholders. Because S Corp shareholders report the income and losses of the company on their own personal tax returns, the company isn’t subject to double taxation.

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S Corp Structure

Shareholders

The shareholders of an S corp are the owners. They’re the ones who “hold” shares of stock.

Depending on how much stock they own, they have varying degrees of influence on the corporation — but they don’t make the decisions or run the day-to-day. Instead, they elect the company’s directors, who take care of all of that. They also vote to remove directors, when it seems like those directors aren’t working in the best interest of the corporation.

Directors

The Board of Directors is elected yearly by the shareholders and they have a more direct involvement with the running of the S corp. They’re obligated to have an annual meeting about the business, as well as elect the corporate officers, set operation policies, expand the business, and authorize financial decisions. If a director doesn’t act in the corporation’s best interests, they can be held personally liable.

Officers

Officers are elected by the Board of Directors and they manage the day-to-day operation of the S corp. There are usually four officers: President, Vice President, Treasurer, and Secretary. They’re in charge of keeping things moving along, managing employees, and taking care of the nitty-gritty.

In order to be eligible to become an S Corp, a company must:

  • Have only individuals, certain trusts, and estates as shareholders.
  • Have no more than 100 shareholders.
  • Be a domestic company.
  • Have solely one class of stock.

And they cannot:

  • Have partnerships, corporations, or non-resident aliens as shareholders.
  • Be an ineligible type of business — including insurance companies, domestic/international sales companies, and certain financial institutions.

How to Set Up an S Corp

The first step for setting up an S Corp is to file Articles of Incorporation with the Department of the Treasury, in the appropriate Internal Revenue Service (IRS) office.

You’ll need to submit Form 2553 Election by a Small Business Corporation, signed by all the shareholders. For instructions on how to submit that form — and where — check out Instructions for Form 2553.

Advantages of an S Corp

Shareholders’ Personal Assets are Protected

With an S Corp — as with other types of corporations — the personal assets of the shareholders are protected in the case of the company getting sued, going into debt, or failing.

No Double Taxation

Because income and losses are passed through to the shareholders’ personal tax returns, S Corps don’t face the “double taxation” that can sometimes occur in other types of corporations.

It Can Help Your Personal Taxes

Because of pass through taxation, the income and losses of an S corp can sometimes offset any other income and losses that a founder may have. This can be especially helpful in the earlier stages of a company.

Easier to Transfer Ownership

With an S Corp, ownership transfer is relatively easy! You don’t have to dissolve and reform if someone leaves or dies; the accounting is pretty simple; and there are no negative tax consequences.

Cash Method of Accounting

While other types of corporations are required to use the accrual method of accounting unless their gross receipts are less than $5 million, S Corps can use the cash method of accounting, as long as they don’t have inventory.

Increased Credibility

Getting certified as an S Corp can lend your baby startup some cred, as it shows you’ve made a formal commitment to — and investment in — continuing your company.

Better Income Taxation

Shareholders are allowed to pull income from an S Corp, which can reduce self employment tax. They can also receive dividends and other tax-free distributions. Not bad!

Disadvantages of an S Corp

Ongoing Fees

One big bummer of an S Corp is that you have to keep paying to stay incorporated. In addition to the initial registration fee, you’ll have to pay a “filing fee” every year to stay registered.

Have to Follow the Calendar Year

S Corps have to follow the calendar year for their tax returns rather than the fiscal year, unless they can prove there’s a really good reason for them to follow the fiscal year.

Only One Type of Stock

Because S Corps can only issue one type of stock, there’s no way to grant different dividends or rights. You are, however, able to issue voting and non-voting shares.

Only Certain People/Groups Can Own Stock

There are restrictions on who can own stock in an S Corps. For example, no foreign citizens can be stockholders and certain kinds of trusts and other groups are also prohibited. Finally, you can’t have more than 100 shareholders total.

The IRS Breathing Down Your Neck

The IRS keeps a close on S Corps because there are a few different ways earnings and dividends can be reported. If you choose to become an S Corp, it’s worth it to make sure you have a great accountant on your team.

Fewer Options for Allocating Income and Loss

While a partnership or an LLC can allocate losses and income to specific shareholders as a part of the operating agreement, that’s not possible with an S Corp. Instead, allocation of losses and income are determined by stock ownership.

Fringe Benefits Can Be Taxed

If a shareholder owns more than 2 percent of an S Corp, any fringe benefits are taxable.

Single Member vs. Multi-Member S Corps

C Corp

“C corporation” or “C corp” simply stands for “corporation.” Corporations are a business entity that exist entirely separately from their owners. They can be taxed, make a profit, and be held liable. In fact, they offer the highest level of protection from personal liability for the owners.

One big downside of a C corp is that it can pay double taxes. The first set is on any profits the C corp makes, while the second set is on the personal tax returns of shareholders, when they’re paid dividends. C corps also require extensive record-keeping, specific operational processes, and strict rules about reporting.

When it comes to stock, C corps can issue stock and shareholders can sell their stock and/or leave the business without affecting the life of the corporation, unlike some other types of incorporation. A C corp is a good option for a company that’s planning on eventually going public.

LLC

“LLC” stands for “limited liability company” and it’s an increasingly popular form of incorporation in the United States. In an LLC, owners get the benefits of both partnerships and corporations. Like S-corps, earnings and losses are passed through individual owners and included on their personal tax returns. Unlike S-corps, they have no limit on the number of shareholders they can have.

However, they also don’t offer stocks, which can make things tricky when it comes to raising money. Without stocks, you also can’t use partial ownership as an incentive for potential employees. In an LLC, you also can’t deduct the cost of employee benefits.

LLCs also aren’t around forever, unlike other forms of incorporation. If a member dies, quits, or retires, the company has to be dissolved and reformed. It can also be tricky to incorporate in the United States because each state has their own rules and fees.

All of these factors mean an LLC may be a better option for a small company, with only a founder or with few employees, rather than a company that’s looking to scale. Or, at the very least, consult a specialist who knows a lot about the types of incorporation before choosing the one you want to go with.

Partnership

A partnership is an agreement between two or more people to form a business together. While S Corps and other types of corporations are businesses that are separate from the individual, for liability purposes, partnerships are not. That means the individual people involved in a partnership can be held personally liable if something goes wrong in the business.

Some partners can work for the partnership, while others might have limited participation. And when it comes to taxes, income tax is paid by the partnership, but profit and losses are divided between the individuals.

Sole Proprietorship

A sole proprietorship is a business that’s owned by one person and one person only. Unlike S Corps and other types of corporations, sole proprietors don’t register with the state. If a one-person business chooses to register with the state as an LLC or corporation, then their business is no longer considered a sole proprietorship.

Converting LLC to an S Corp

The process of converting from an LLC to an S Corp is pretty simple. The very first step is making sure you business even qualifies to be an S Corp — check out the requirements above.

If your company does meet those requirements, then you can follow the statutory conversion process, which means you don’t have to dissolved your LLC and reform it. Instead, all of your assets and liabilities transfer automatically. In order to follow that process, you have to file a certificate of conversion and any other documents your state requires.

A couple of states, however, still don’t allow statutory conversions. If it turns out your state is one of those, you’ll have to complete a more complicated process called a statutory merger. Either way, you can find all of the info you need on your state’s business filing agency website.

Finally, you have to file Form 2553, Election by a Small Business Corporation, with the IRS in order to elect S corporation tax status.

Also, quick note. You don’t have to convert your LLC to an S Corp if the only reason you’re doing it is to get tax benefits. An LLC can be taxed like a sole proprietorship, a partnership, a C Corp, or an S Corp. Just make sure you qualify.

Converting an S Corp to a C Corp

The major tax overhaul of 2018 has many corporations considering converting from S Corp status to C Corp status, in order to take advantage of the new, lower tax rate. If this is something you want to do, you have to first get permission from the IRS to convert. Then? Hire an accountant. The process is more complicated than the average startup founder without years of experience in tax law should tackle on their own. This is one place where it’s worth it to pay someone else, rather than trying to bootstrap it.

Dissolving an S Corp

In order to dissolve an S Corp, you have to file Articles of Dissolution, just like you had to file Articles of Incorporation to incorporate. While the process varies slightly from state to state, here are some general steps you’ll need to take.

1. Call a Board Meeting

The first step is getting your Board on board! Call a board meeting so that they can formally vote to dissolve the company. You’ll need signed approval from the Board of Directors as well as the majority of shareholders in order to dissolve the company.

2. File a Certificate of Dissolution

Get ahold of the Office of the Secretary of State — or the Incorporation Bureau or Corporation Commission or Corporation Agency or whatever the state in which you incorporated calls it — and get the necessary forms to submit a Certificate of Dissolution.

3. Let the IRS Know

Now it’s time to let the IRS know that you’re no longer in business! First, pay all of the taxes you owe to both the state and to the federal government. THIS IS REALLY IMPORTANT, because you won’t get a "consent to dissolution" or a "tax clearance” if you’re not all paid up. You usually need those forms to obtain formal dissolution of a corporation from the Office of the Secretary of State. when you’re filing your tax returns, be sure to mark the box, "Final Return."

4. Close Down All Business Agreements

Finally, make sure to close down any bank accounts, lines of credit, permits, licenses, and service accounts associated with your S Corp. And make sure you customers and vendors know what’s up too!


About the Author

The Startups Team

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