How Do S Corporations Work?

Summary: Particularly for certain smaller businesses, the S corporation can be a much more beneficial entity than the traditional C corporations, but there are strict rules. Click through for an introduction to the advantages and drawbacks.

S corporations are entities that can pass corporate income, losses, deductions and credits through to shareholders for federal tax purposes. Shareholders report the flow-through of income and losses on their personal tax returns and are assessed a tax at their individual income tax rates. The Tax Cuts and Jobs Act (TCJA) also gives S corporation owners a 20% deduction on income.

An S corporation offers investment opportunities from the sale of stock and the coveted protection of limited liability. This means that company directors, officers, shareholders and employees enjoy limited liability protection. Your business can continue to exist even if the owner leaves or dies. The good news, too, is that in general S corporations have to file taxes only yearly and not quarterly like C corporations.

It sounds like a good deal, but not every company can be an S corporation. You have to meet the following requirements:

• Be a domestic corporation.
• Have only allowable shareholders: individuals and certain trusts and estates, but not partnerships, corporations and nonresident aliens.
• Have no more than 100 shareholders.
• Have only one class of stock.
• Not be an ineligible corporation, such as certain financial institutions, insurance companies and domestic international sales companies.

If you meet these qualifications, you have to take a number of formal steps to become an S corporation. You have to choose a legal name and reserve it, apply for a business license and other certificates specific to your industry, and obtain an Employer Identification Number. Rules may vary depending on the jurisdiction.

Also, despite the pass-through advantages, S corporations still have to meet certain responsibilities. They must prepare and file income tax and estimate tax forms. (Some of these are especially complicated.) They also are responsible for Social Security and Medicare taxes, federal unemployment taxes, and relevant excise taxes.

The individual S corporation shareholders are responsible for income and estimated taxes.

But while there’s a lot to love, there are a few things to consider:

• You cannot expand with international ownership — citizens and permanent residents only.
• With the 100-shareholder limit, there may be practical limits on growth.
• The IRS can be fussy: Any errors among the various filing requirements can inadvertently result in the termination of S corporation status. Indeed, the IRS typically looks very closely at S corporation filings, making sure there’s a clear line between salaries and dividends, as they are taxed differently. Be prepared for detailed IRS scrutiny in this area.

The S corporation is just one of a number of ways to organize your business. Is it right for you, or is there another way that would be more appropriate? We can help walk you through the financial and practical details.

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