A Guide to S Corporations

Choosing the right legal and tax structure can make a significant difference in your success as a business.

An option that often flies under the radar for many entrepreneurs is the S Corporation, or S Corp. This business setup offers a unique blend of tax advantages, liability protection, and operational flexibility.

But what exactly is an S Corp, and how can it benefit your business?

In this guide, we'll delve into the intricacies of S Corps, demystify their pros and cons, and provide a step-by-step roadmap for establishing and maintaining one.

Whether you're a seasoned entrepreneur or just starting your business journey, forming an S corporation today can help you save on taxes and protect your assets.

Understanding S Corporations

An S Corp, is a specific type of tax classification that you can choose to operate your business as. The defining feature of an S Corp is its pass-through taxation model.

Unlike traditional C corporations, which are taxed at both the corporate level and the shareholder level, S Corps avoid this double taxation. Instead, an S corporation's income, losses, deductions, and credits pass through to the shareholders' personal tax returns.

This structure means that income is taxed only once. This can lead to significant tax savings, especially for small—to medium-sized businesses.

To become an S Corp, a business must meet certain requirements set by the IRS (Internal Revenue Service):

• A limited number of shareholders (100 or fewer).
• Shareholders must also be U.S. citizens or residents.
• Can only have one class of stock.

Benefits of an S Corp

The unique structure of an S Corp offers several benefits for business owners.

We've already talked about the primary advantage of forming an S Corporation: avoiding double taxation. But there's more.

Limited Liability Protection. Shareholders are typically not personally responsible for the business debts and liabilities. This protection is vital as it allows investors and owners to protect their personal assets, such as homes and savings, from business-related lawsuits or debts.

Self-Employment Tax Savings.In an S Corp, only the salary paid to the employee-shareholders is subject to employment tax. The remaining can be given to shareholders as distributions - not subject to self-employment taxes. This can save your business money, especially if you can justify a reasonable salary while taking additional profits as distributions.

Credibility. An S corporation's corporate structure will improve how investors and lenders see the business, making business growth easier.

Steps to Set Up an S Corp

While the allure of an S Corp is undeniable, the process of forming one might seem daunting. Fear not, as we break down the steps involved in a clear and concise manner:

Step 1: Choose Your Business Structure

Before you can elect S Corp status, you need to have a qualifying business entity: an LLC (Limited Liability Company) or a C-corporation.

LLCs are flexible and simple. They're ideal for entrepreneurs who want fewer formalities and more personal control over their business decisions. LLCs also provide pass-through taxation, beneficial for many small to medium-sized businesses.

C Corps are suitable for businesses that plan to grow significantly, possibly going public or issuing multiple classes of stock. This structure appeals to potential investors and can accommodate more complex business arrangements.

Actionable Tip: Research both LLCs and C Corps thoroughly to determine which structure aligns best with your long-term business goals.

Step 2: Pick a Business Name

Choosing the right name establishes your business identity and can influence everything from branding to legal recognition. Here are some key requirements to consider:

1. Unique. Your business name must be unique within your state to avoid confusion and legal issues. It should not be similar to existing business names, which could lead to trademark disputes or brand confusion.
2. Appropriate. Avoid using profanity, offensive language, or terms that could be misleading about the nature of your business. Including words like "bank" or "insurance" in your name may require additional regulatory compliance.
3. Compliant. Each state has specific naming requirements and prohibitions. It's crucial to familiarize yourself with these rules to ensure your business name complies.

Actionable Tip: Once you have a few potential names in mind, use an online tool like the LLC Attorney’s tool to check the availability of your chosen name in your state.

Step 3: File Articles of Incorporation

Filing your Articles of Incorporation is an essential legal step in formalizing your business as a corporation. It establishes your business under the law and includes several crucial pieces of information. Whether you choose to be an LLC or corporation, there are a few pieces of information that may be asked of you:

1. Business Name. As chosen and verified in previous steps for uniqueness and compliance.
2. Office Address. The official business address where your corporation will receive correspondence.
3. Registered Agent. The individual or service authorized to receive legal documents on behalf of your corporation. They can be an individual or hired service. They must be available during regular business hours, over 18, and have a physical address in the state of incorporation.
4. Ownership Structure. Details about the corporation’s stock, including the number of shares authorized to issue and the value of each share, if applicable. This section outlines the initial division of ownership among shareholders.

Actionable Tip: To file your Articles of Incorporation, obtain the necessary form from your state’s Secretary of State office. Each state has its own specific form and filing requirements. After filling out the form, submit it along with the required filing fee, which varies by state. Ensure all information is accurate to avoid delays.

Step 4: Issue Stock

Issuing stock directly impacts ownership and operational structure. S Corps have specific requirements set by the IRS that differentiate them from other business entities:

1. Shareholder Limit. S Corps are limited to no more than 100 shareholders. This rule preserves the benefits of pass-through taxation while maintaining a manageable number of investment stakeholders.
2. Stock Class. S Corps are allowed to issue only one class of stock. While they can have voting and non-voting shares, all shares must have identical rights to distributions and liquidation proceeds. This simplifies the ownership structure and compliance with IRS regulations for pass-through entities.

Actionable Tip: Prepare and distribute stock certificates to your shareholders to formalize their equity in the corporation. Maintain detailed records of all issued stock and ensure that the corporation complies with all S Corp regulations.

Step 5: Elect a Board of Directors and Appoint Officers

A Board of Directors plays a key role in overseeing the corporation’s strategic direction and ensuring accountability, while officers manage the day-to-day operations.

Requirements:

• Board of Directors. S Corporations must have at least one director, though larger corporations often benefit from having more. Directors are elected by the shareholders and are responsible for policy and financial decisions.
• Officers. Once the board is in place, it appoints officers (such as a CEO, CFO, and Secretary) who are responsible for the corporation's daily management. These officers execute the board’s strategies and manage operational tasks.

Actionable Tip: Organize an initial meeting of shareholders to elect your Board of Directors. During this meeting, the newly formed board should appoint the corporation’s officers. Record these meeting minutes, as they are important legal documents that record the decisions made regarding the governance of the corporation. This approach ensures clarity in roles and responsibilities, setting a strong foundation for corporate operations.

Step 6: Obtain an Employer Identification Number (EIN)

An Employer Identification Number (EIN) is essential for running an S Corporation. This unique nine-digit number, issued by the IRS, is an identifier for your business and used for the following:

• Federal Taxes. The EIN is used to identify the business for tax purposes. It is required for filing various business tax returns.
• Hiring Employees. If you plan to hire employees, an EIN is necessary for setting up payroll as it is used to report taxes withheld on behalf of your employees.
• Opening a Business Bank Account. Most financial institutions require an EIN to open a business banking account. This is necessary for keeping finances separate from personal accounts and maintaining professional records.

Actionable Tip: Apply for your EIN immediately after establishing your business entity. You can apply for free using IRS Form SS-4. The form can be completed online, by fax, or by mail. Online applications are processed immediately, and you will receive an EIN as soon as you finish the application.

Step 7: Elect S Corp Status

To elect S Corp status, you must complete and file Form 2553(available on the IRS website) and provide the requested information.

It requires information about the business, such as the name and address, the Employer Identification Number (EIN), and details about the shareholders. The form also asks for the tax year the election should take effect.

To be effective for the current tax year, Form 2553 must generally be filed no later than two months and 15 days after the beginning of the tax year when the election is to take effect. For a new business, it should be filed at any time during its first tax year.

Actionable Tip: Consult with a tax professional to ensure that eligibility criteria are met and that Form 2553 is filled out accurately. This helps avoid processing delays or unexpected issues with the IRS, beginning your S Corp status effectively.

Step 8: Apply for State and Local Business Licenses

The next step is to get the federal, state, and local licensing and permits for your specific business.

• Federal Licenses. Depending on your industry, federal licenses may be required. For example, businesses involved in broadcasting, transportation, or alcohol and tobacco sales must obtain specific federal licenses.
• State Licenses and Permits. These vary significantly depending on the state in which your business operates and the industry. Common state-regulated industries include healthcare, education, food services, professional licenses, environmental permits, and health department permits.
• Local Licenses and Permits. At the local level, you may need zoning and land use permits.

Actionable Tip: Your local chamber of commerce or business advisory council will provide information on the specific licenses and permits you need. Apply for all licenses and permits before starting operations to comply with legal standards and avoid penalties.

Step 9: Create Corporate Bylaws

Corporate bylaws provide a framework for your business operations and management. They create rules and procedures for how the business functions and ensure it runs smoothly.

What Corporate Bylaws Include:

• Definition of the powers and duties of directors and officers, including how they are elected and removed. It also outlines the structure of the management team and its authority in corporate decision-making.
• Details how stock is issued, including any limitations or rights associated with the shares.
• The rules for how voting is conducted, including how votes are counted.
• When and how annual meetings are to be held, including notice requirements and the agenda for such meetings.

Actionable Tip: Draft and adopt corporate bylaws during your corporation’s initial board meeting. This ensures that all directors are aligned from the start and fully understand the corporation's operational guidelines. Formalizing these rules early prevents misunderstandings and conflicts within your organization as it grows.

Step 10: Schedule and Hold Annual Meetings

Scheduling and holding annual meetings is a legal requirement for S Corporations. These meetings ensure transparency, accountability, and active engagement between shareholders, directors, and officers in discussing the corporation's performance and strategic direction.

Requirements:

• Regular Meetings. S Corporations must hold at least one board and one shareholder meeting annually. These meetings provide opportunities to review financial reports, discuss strategic decisions, elect directors, and make other key corporate decisions.
• Detailed Minutes. These minutes should accurately record the discussions, decisions made, and voting outcomes. They serve as an official and legal record of the corporate activities and decisions.

Actionable Tip: To ensure compliance and organizational efficiency, schedule these meetings well in advance and create an agenda.

How Do S Corp Taxes Work?

To understand how S Corp taxes work, let's explore some concepts; pass-through taxation, self-employment taxes, and the reasonable salary requirement.

Pass-Through Taxation

An S Corporation is a "pass-through entity', allowing profits and losses to be passed directly to shareholders’ personal tax returns. This avoids the double taxation typically associated with C Corporations. S Corps report income and losses on each shareholder's personal tax return and pay tax at individual income tax rates. This method can result in considerable tax savings, especially if the individual’s personal tax rate is lower than the corporate tax rate.

Self-Employment Taxes

Generally, business earnings are subject to self-employment taxes, which include Social Security and Medicare taxes. However, S Corporation shareholders can save on these taxes. Only the salary paid to the shareholder-employees is subject to employment taxes.

Any additional profits distributed as dividends are not subject to self-employment taxes. This distinction can result in significant tax savings, making it a compelling reason for many businesses to elect S Corp status.

Reasonable Salary Requirement

One of the IRS requirements for S Corps is that any salaries paid to members must reflect what one would expect to pay for similar services in the marketplace.

The IRS scrutinizes this closely because some S Corps might be tempted to pay lower salaries and distribute most of the income as dividends to reduce employment tax liabilities.

The IRS has the right to decide whether a salary is reasonable. It can even reclassify business earnings as wages, which then become subject to employment taxes.

How to determine a reasonable salary boils down to industry standards, the individual’s roles and responsibilities, and the hours worked.

As you can see, S Corporations taxation offers several benefits. However, these benefits come with certain responsibilities to ensure compliance with IRS rules.

We recommend consulting with tax professionals to navigate the rules effectively and make the most of the S Corp taxation structure. The specifics for how your S Corp’s taxes work will vary depending on your location, and your business!

Maintaining S Corp Status

Gaining S Corporation status is one thing. Maintaining it requires adhering to a variety of legal and regulatory standards. Here’s a detailed look at what maintaining S Corp status entails.

1. Filing Annual Reports.Most states require S Corporations to file annual reports. These reports typically include updates on the corporation’s address, its directors and officers, and sometimes a summary of financial performance. Filing these reports on time is crucial as failure to do so can result in penalties, fines, or even losing S Corp status.
2. Holding Meetings. S Corps must hold at least annual meetings of shareholders and directors. In these meetings, participants should review the company’s performance, make strategic decisions, and fulfill other statutory requirements. Properly documented minutes serve as a legal record that the company is operating according to its bylaws and state law.
3. Maintaining Corporate Records. Keeping thorough corporate records is essential. This includes meeting minutes and financial transactions, contracts, shareholder communications, and changes in corporate structure or management. These documents show that the corporation is a separate legal entity–essential for protecting shareholders’ limited liability status.

Actionable Tip: Take advantage of technology and professional help! Use accounting software to keep financial records organized and up-to-date. Software designed for small businesses can help track expenses, manage payroll, and ensure accurate financial reporting.

Additionally, hiring a professional, such as a certified public accountant (CPA) who specializes in small business or specifically in S Corporations, can be invaluable. They can assist in preparing financial statements, filing tax returns, and ensuring compliance with various regulatory requirements.

Maintaining S Corp status requires attention to both administrative and compliance. By establishing routine workflows to meet these obligations and seeking professional help when necessary, you can ensure your business remains in good standing and continues to reap the benefits associated with this business structure.

Advantages and Disadvantages of S Corp Status

Choosing S Corporation status has several advantages but also comes with certain drawbacks that business owners should consider.

Advantages:

1. Tax Advantages. The S Corp structure can significantly reduce your tax burden, which is particularly beneficial during the formative years of a business.
   1. S Corps can divide their business income into both reasonable salaries and dividends, you can reduce your self-employment tax obligations.
   2. S corp status allows for deductions related to business expenses and employee wages.
   3. S corps enjoy pass-through taxation. Business income flows directly to shareholders, which helps avoid the double taxation that C Corps face.
2. Ease of Asset Transfer. S corps can transfer interests or adjust property bases without facing negative tax implications or complex accounting requirements.
3. Enhanced Credibility. The formal structure of an S corp can enhance a business’s credibility with potential customers, suppliers, employees, and investors, illustrating the owner's commitment to the enterprise.

Disadvantages:

1. IRS Scrutiny. S corps are closely monitored by the IRS, particularly regarding how they compensate employees. To avoid payroll taxes, some S corps may misclassify salaries as distributions, which the IRS vigilantly checks.
2. Distribution Restrictions.Profits and losses must be allocated strictly based on ownership shares, limiting flexibility in how earnings are distributed.
3. Risk of Status Termination.The IRS may revoke an S corp’s status if compliance failures occur, such as improper allocation of profits and losses or errors in essential filings. Prompt correction of these errors can usually prevent serious consequences.
4. Operational Costs.Establishing an S corp involves time and financial investment. Requirements include filing articles of incorporation, obtaining a registered agent, and covering various fees. Although these costs are often manageable and tax-deductible, they require upfront payment.
5. Ongoing Expenses.S corps may incur recurring costs, such as fees for annual reports and possibly state franchise taxes. While generally affordable, these expenses are a consideration for any business budget.
6. Growth Limitations. Shareholder restrictions and their qualifications can hinder rapid growth and the attraction of venture capital. particularly for businesses looking to scale quickly or attract institutional investors.

While the tax advantages and liability protection are compelling, the administrative burden and shareholder restrictions might pose challenges, particularly for businesses planning expansive growth or those with international investors.

Get Your S Corp Set Up The Right Way

The S Corporation, or S Corp, offers a blend of tax advantages, liability protection, and operational flexibility, making it an attractive option for many business owners.

Throughout this guide, we've explored what an S Corporation is, its benefits such as pass-through taxation, liability protection, and potential savings on self-employment taxes, and provided a detailed roadmap for setting it up.

We've covered the essential steps to help you establish your S corporation effectively, from choosing the right business entity type to maintaining your status once you've achieved it.

Given the complexities involved, we highly recommend that you seek professional help to get your business set up on the right path.

Consulting with a tax professional or a legal advisor can provide personalized guidance and help ensure that you choose the structure best suited to your business needs and that you remain compliant with all relevant laws and regulations. This support will help you set up your S corporation correctly and make the most of its benefits.