Building a business is full of tradeoffs—which start with the type of entity you choose. Forming and operating your small business corporation as a C corp, for example, allows for huge growth potential through limitless issuance of stock but comes with a heftier tax liability through double taxation. S corporations offer a compromise of sorts, allowing your company to grow through limited stock issuance, while accessing the tax advantages of other business formats, such as an LLC, general partnership, or sole proprietorship.
What is an S corporation?
An S corporation (S corp) is a legal business entity type and tax designation defined by its pass-through tax status. S corps forgo paying corporate taxes and instead pass all corporate income, losses, deductions, and credits through to shareholders for purposes of federal taxation. Shareholders in S corps report distributions from the business on their personal income tax returns, and taxes are assessed at their personal income tax rates. In effect, this allows the S corp to avoid so-called double taxation on corporate earnings.
Eligibility requirements for starting an S corporation
There are several conditions that S corps must meet, as dictated by the Internal Revenue Service (IRS). Some of those conditions are as follows:
- S corps must be domestic corporations—they cannot be foreign companies.
- S corps are not permitted to participate in certain business sectors, such as insurance or some financial services.
- S corps may not issue stock to more than 100 shareholders, and that stock can only be of a single class. S corps may only offer common stock (with voting rights); they may not offer preferred stock (dividend priority, no voting rights).
- S corp shareholders must be citizens or permanent residents of the US—they may not be non-resident aliens of the US or foreign citizens.
- S corp shareholders must be individuals—they may not be other corporations.
How to start an S corporation
To form an S corporation, a small business owner must take certain steps prescribed by the IRS:
- Naming. Choose a unique business name; it may not be registered to any other business entity.
- Appoint officers. Appoint a board of directors, a registered agent, and other corporate officers needed to run your S corp.
- Schedule and hold annual meetings.Boards are required to keep detailed minutes of these meetings.
- Incorporate. File articles of incorporation with the IRS and secretary of state in your state of operation. Most states will offer an articles of incorporation form, which can be acquired from the local secretary of state’s office. Shareholders will need to sign the articles of incorporation prior to filing.
- Get licensed. Apply for all applicable state, federal, and local business licenses and permits.
- Get an EIN. S corps must file a Form SS-4 to obtain an employer identification number (EIN) from the IRS.
- File tax forms. S corps must file Form 2553 (Election by a Small Business Corporation) with the IRS. Compared to other business formats, like sole proprietorships and LLCs, S corporation tax liability can be more complicated due to the stricter scrutiny the IRS applies toward these businesses. Stricter scrutiny is intended to discourage business owners from forming their ventures as S corps in an effort to evade taxes.
- Make rules. Write and file corporate bylaws, which govern the appointment and removal of board members and other corporate officers, as well as procedures for issuing stock, scheduling meetings, and conducting board member votes.
- Issue stock. Your board will have to approve the number of shares issued, which can be distributed in the form of paper or electronic certificates. In addition to board approval, you can provide prospective shareholders with a report containing an independent third-party valuation of the stock, though this is not a requirement for issuing stock.
You will need to pay filing fees to various authorities, both state and federal, when submitting your articles of incorporation, acquiring licenses, and obtaining an EIN. The cost to start an S corp varies by state, based on filing fees and state taxes, but you can expect to pay between $800 to $3,000, excluding any lawyer’s fees, should you choose to hire one.
Considering the S corp designation for your small business requires that you ask yourself, any potential business partners, and perhaps your attorney a number of important questions:
- Do you need or wish to raise money for your business through the issuance of stock?
- Are you comfortable with limitations on the number of shareholders you can issue stock to?
- Do you foresee having investors who are foreign individuals or business entities?
- Do you foresee selling your company at some point?
- Can you afford double taxation? If not, are you comfortable with stricter IRS scrutiny?