What Is It?
What is an S-Corp Exactly?
That's A Great Question... and Here's My Take on It
Technically, an S-Corp isn’t a Corporation at all – It’s a special tax treatment.
It’s called an S-Corp because it comes from sub-chapter “S” of the Internal Revenue Code. The letter “S” in S-Corp, according to the code, stands for “Small” or “Small Business Corporation”. This special tax treatment is applied through and granted by the IRS. So, if you ask and they say no… you will NOT be treated as an S-Corp. But if they say yes… oh boy – let the savings begin!
So, what’s so special about an S-Corp? Well… without going to deep in the tax code, generally speaking, an S-Corp allows the business to “pass through” to the owners, the profit and losses of the business. This, in turn, allows for the business itself to not pay Federal taxes and possibly pay a lower Federal tax at the owner’s level. This is a great way to avoid the double taxation of regular Corporations where taxes are assessed once at the corporate level and again on the owner’s personal income tax return (Dual Taxation).
Keep in mind, however, that even though the income and expenses of the business are passed through to the owners, the business itself still must file its own separate tax return. In the case of the S-Corp, the required form is the 1120S (it ends with an “S” … who would have guessed it?). Also note that the due date for these returns is different from our personal return. The due date for these returns is generally March 15th whereas for our personal returns, the due date is generally April 15th.
How Do You Form One?
Technically (there’s that word again), you can’t “form” an S-Corp. Remember that an S-Corp is a type of special tax treatment – it’s not an actual type of business formation. Therefore, if you want the benefits of S-Corp status, you would first need to form either a Corporation, an LLC or a Multi-Member LLC and then elect to be treated as an S-Corp by requesting such status from the IRS. Which also means that the laws you must follow will be dictated by the underlying entity you choose (Corporation or LLC).
Preferably, the IRS likes for the S-Corp application to be submitted within 3 months of the business being formed or at the beginning of the year. However, if you formed your business sometime ago and it didn’t, at the time, make sense to choose S-Corp status, you can still submit an application and just request what is called a Late Relief Election.
With this in mind, there are some rules and regulations that you should give careful consideration to in regards to becoming an S-Corp. In order to obtain S-Corp status, the Internal Revenue Code states that a business has to meet certain requirements and those requirements are:
- The business must be organized or incorporated in the U.S. (a domestic entity)
- It can only have one class of stock (Sorry… no preferential treatment)
- It can not have more than 100 shareholders (However… a family of 5 can count as 1)
- Note: Partnerships, Corporations and Nonresident Aliens cannot be an eligible shareholder.
The Good, The Bad & The Ugly?
Is there really an ugly side to being taxed as an S-Corp?
But, there are some advantages and there are some disadvantages... just like anything else. That’s why it’s extremely important to know what your goals are before deciding to make this election. Here is my list of what I think are some advantages and disadvantages of S-Corp status.
- The taxes. Generally, when are taxed as a regular corporation, you will pay taxes twice. Once at the corporate level and then when you take a payment (either a wage or a dividened). Well, with the S-Corp, all of profit and losses are passed right to the owners, so they will only be taxed once… and pay taxes at their individual tax rate.
- Special strategies. With an S-Corp, you can change the color of money (an accountant expression), meaning that there are certain strategies that you can employ that can reduce the amount of taxes that you pay. For example: you can reimburse yourself for the cost of business use of your cell phone or vehicle, not pay tax on that amount on your personal taxes and the S-Corp gets to write it off.
- Reduction in Self-Employment taxes. One of the most significant benefits to S-Corp status is the fact that you can set yourself up on a salary (which must be reasonable), only pay taxes on that amount on your individual return and then deduct that amount from the business. That is something that you cannot do as a Sole-Proprietor, Partnership or Single Member LLC.
- There are plenty more…. But I’d have to write a book to tell you.
- The restrictions. As you can see from the qualifications that are required to form an S-Corp, there are some things that may not be beneficial for you. The biggest one being the restriction on who can be a shareholder. If you have a partner/shareholder who is a Nonresident Alien, you cannot and will not be granted S-Corp status. Another one is the one class of stock. The reason that you may want to have more than one class of stock would be to separate who has voting power (the decision makers) vs who just gets a piece of the profits (an investor). But with only once class of stock… anyone owning more than 2% becomes a decision maker.
- The administrative obligation. Due to the fact that there is a lot more scrutiny from the IRS, it’s very imperative that the paperwork and books be in pristine order. Which means that there can be no lack in organization. Everything must be tracked. Documents must be kept for substantiation because if something goes wrong… your S-Corp status can be revoked.
- Additional costs. As I just mentioned above, there are some administrative obligations that must be met in order to maintain the S-Corp status and with that obligation comes some additional costs. For instance, you will need to incorporate a bookkeeping system, run payroll, hire someone to do it for you if you don’t want to or can’t do it yourself and then there is the additional cost of the tax return for the business itself and the possible additional cost that will be added to your personal tax return for the additional forms generated by S-Corp that must be included with your personal tax return. Also consider that in order to be taxed as an S-Corp, you will need to be an actual entity (LLC or Corporation) which means that there may be State fees as well.
- Speaking of States. Unfortunately, S-Corp is a Federal tax treatment. Meaning that it will be treated the same across all 50 states on the Federal side. And even though the States do recognize businesses that are taxed as S-Corps, the treatment varies from State to State. So, even though you may save some money on the Federal level, those saving may be eaten up by the State fees and taxes.
The Bottom Line Is This.
S-Corporations are great for Sole Proprietors and Single Member LLCs who are in the beginning phase of their business, but is starting to see significant growth in their profits.
The transition from Sole Proprietor or Single Member LLC to an S-Corp is a great way to save on taxes and create more flexibility for the business operations. But again, due to the requirements, additional costs and complexities that come with this type of tax status, the application for it should be taken with caution. Additional Note: Please keep in mind that Sole Proprietors must first become either an LLC or a regular corporation FIRST, then choose to be taxed as a S-Corp. See what I mean?