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What is an S corporation?

When you’re setting up a new business, you’ll be presented with a range of options. If you opt to register as a corporation, you’ll need to choose between C corporation vs. S corporation. Learn more about what all of this means below.

S corporations explained

The “S” in S corporation comes from IRS tax code, referring to subchapter S. An S corporation is a type of legal structure given to corporations with less than 100 shareholders. The idea is to tax the corporation as a partnership, while still providing the benefits of incorporation.

S corporation taxes are at the heart of its definition. While C corporations are liable for corporate and personal income tax, S corporations are pass-through entities with income passed directly to shareholders to avoid double taxation.

There are a few distinguishing characteristics of S corporations:

  • The corporation must have 100 or less shareholders.

  • The corporation must be domestic.

  • Only one type of stock is allowed.

  • Shareholders must be specific types of trusts and estates, tax-exempt organizations, or individuals.

  • Corporations, partnerships, and non-resident aliens cannot be shareholders.

  • Corporate income, credits, losses, and deductions are passed through to shareholders.

  • Shareholders report the income and losses on personal tax returns.

C corporation vs. S corporation

While smaller businesses often choose the S corporation structure, another option is to incorporate as a C corporation. These two types of corporations have several traits in common. For example, they both offer limited liability protection, which means that outside creditors can’t pursue the personal assets of owners.

The major difference between C corporation vs. S corporation is the issue of S corporation taxes. With a C corporation, income is taxed at the corporate level as well as when it’s paid out in dividends. An S corporation isn’t subject to double taxation. There are also fewer reporting requirements for S corporations, who only need to file taxes once rather than on a quarterly basis.

However, C corporations benefit from being able to sell multiple types of stock, to unlimited shareholders. They can also involve all types of shareholders, including other corporations or overseas investors. S corporations are more limited when it comes to attracting venture capital.

S corporation pros and cons

As with any business decision, there are plenty of S corporation pros and cons to consider.

S corporation advantages

  1. Limited liability protection for officers, employees, shareholders, and company directors.

  2. Investment opportunities for growth through sales of stocks.

  3. Pass-through S corporation taxes, allowing owners to report profit and loss on personal tax returns.

  4. Avoidance of double taxation because income is only taxed once.

  5. Easier filing requirements in comparison to C corporations.

  6. Easy transfer of ownership without tax consequences.

For new businesses, registering as a corporation in general helps build credibility with clients, employees and investing partners.

S corporation disadvantages

On the other hand, an S corporation won’t be the right structure for everyone. Here are a few of the potential downsides.

  1. Shareholders are limited to U.S. citizens and permanent residents, which won’t work for businesses looking at global growth.

  2. You are limited to only 100 shareholders, who can’t include other corporations.

  3. It’s easier to get caught out by small tax errors as an S corporation, because requirements are stricter. You’ll need to pay for a good accountant.

How to form an S corporation

Are you ready to get started with registering your S corporation? First, you’ll need to choose a business name and file Articles of Incorporation with the Secretary of State. Filing fees are typically involved as well, although this will vary depending on the state of incorporation.

When you first register a new corporation, you’re automatically a C corporation by default. File Form 2553 with the IRS to switch over to S corporation status.

As part of registering a new corporation, it’s also required to form a board of directors. They’ll need to hold a formal meeting to create company bylaws, appoint officers, and take care of any other administrative business. Finally, you can sell and distribute your stock certificates to shareholders.

No matter which type of corporation you choose, keeping accurate financial records is vital. Set up a good system for accounting to record and prepare profits, losses, and tax paperwork. This will put you in good stead when tax time rolls around. 

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