S Corp For Dummies
There is a ton of information on S corporations (S corps) online and social media about this commonly used tax election. I’m going to simplify everything you need to know in an “S corp for dummies” format:
S Corp for Dummies – Basics:
- Tax election, NOT a legal entity – S corps are not legal entities. They are a tax election. You start your business as an LLC or C corporation and then elect to be taxed as an S corp.
- The “S” commonly stands for small business corporation – S corps cannot have more than 100 shareholders.
- S corps do not pay taxes – Unlike C corporations, S corps don’t pay federal income tax at the corporate level. Instead, the company’s profits and losses pass through to the shareholders, who report them on their personal tax returns.
- Single class of stock – This is simple in itself. S corps can’t issue different classes of stock.
- U.S. individual ownership – Generally, shareholders of S corps must be U.S. citizens or full-time residents. Entities or foreign individuals cannot own S corps.
Who are S Corps Best For?:
- High margin businesses – S corps are best for businesses that have high income and low expenses. We recommend that you have a conversation with a CPA regarding an S corp election once you have $80k in annual profit.
- Businesses going to be in operation 3+ years – Electing your business to be taxed as an S corp involves a great deal of new compliance and government registrations. If you are only planning to be in operation a year or two, the tax savings may not be worth the time it takes to get this all set up and later dissolved.
- Businesses with one, two, or three owners – S corps are inflexible as it relates to distributions and allocation of income. The more owners an S corp has, the more frustrating it becomes for owners.
- Active businesses – Passive investments, such as rental properties, don’t receive a tax benefit for being an S corp.
S Corp for Dummies – Advantages
- Elimination of self-employment tax – This is the most common reason for your business to be taxed as an S corp. With an S corp you only pay FICA/self-employment tax on your reasonable salary rather than 100 percent of your business profits. Since your reasonable salary is less than your business profits (if done correctly), you will pay less in taxes.
- Additional tax strategies – There are additional tax strategies available for S corp owners, such as the Augusta Rule.
- Continuous existence – S corps are a distinct entity so they exist indefinitely.
- Stock issuance – Unlike single-member LLCs, S corps are able to issue stock. The ability to issue stock makes raising money or obtaining outside investment more attractive.
- Lower audit rate – S corps have a lower IRS audit rate compared to LLCs.
S Corp for Dummies – Disadvantages
- Additional costs – There are additional costs that come with an S corp election, including an additional tax return fee, payroll costs, and additional taxes.
- Additional compliance – The IRS requires additional compliance for S corps. This leads to additional time and knowledge to ensure your business stays out of trouble.
- Reduced retirement contributions – When a business becomes an S corp, the calculation of maximum retirement contributions change from being based on business profits to owner W-2 wages. This reduces the amount of potential retirement contributions you can make through a Solo 401k, SEP IRA, or traditional 401k.
- Lack of flexibility – If you have more than one owner, distributions must be taken at the same time in the pro-rata percentage of your ownership. You cannot issue distributions in the amount of your choosing or you risk violating S corp requirements. For example, if your business distributes $100 and the ownership percentage between two partners is 60%/40%, partners must receive a distribution of $60 and $40, respectively. No other amount or allocation is allowed.
- Limits social security – Social security benefits are based on W-2 wages. Tax advisors often recommend having the lowest possible W-2 salary to save on taxes. However, this potentially reduces your social security benefits at retirement.
- Payroll taxes on children – With an LLC, you don’t need to pay FICA on wage payments to your children. With an S corp, you do.
Additional Compliance Requirements
- Formal payroll – You must run at least one formal payroll, annually, while withholding taxes. If you need a referral for a payroll processor, please let me know by clicking here.
- Additional tax return – Owners of S corps must file an additional tax return, the Form 1120-S.
- Annual board of directors meeting minutes – The IRS requires S corps have at least one formal board of directors meeting, annually, with documented meeting minutes. You can find a board of directors’ meeting minutes template at the following link – Click Here.
- Accountable plan – An accountable plan is required for the business to reimburse the owner(s) for personal payments made on behalf of the business. Your business can use our S corp accountable plan template which can be found at this link – Click Here.
How to Form an S Corporation
- Start a business and obtain an EIN from the IRS – Select a business name and register for an employer identification number (EIN) with the IRS. It’s free. You can apply for an EIN at the following link – Click Here.
- Incorporate as an LLC or C Corporation with your secretary of state – We recommend incorporating your business as an LLC in the state where you reside.
- File Form 2553, Election by a Small Business Corporation – Prepare, sign, and fax in a completed Form 2553. You can find instructions on how to complete a Form 2553 here – Click Here.
- Wait for IRS acceptance of the S corp election – You should hear back from the IRS within 2-3 months that your S corp election has been accepted.
- Issue and purchase stock – The business issues stock to the shareholders and shareholders pay for the issued shares. When starting a new business the value of the stock is usually minimal, most commonly, $0 or $1.
An S corp can be an excellent entity choice for small to mid-sized businesses looking to reduce their taxes. However, it’s essential to weigh the benefits and drawbacks carefully and consult with an attorney and CPA to ensure it’s the right fit for your business needs.
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About the Author
Brett Rosenstein
Founder of S Corp Advantages
Certified Public Accountant
Brett is the founder and president of S Corp Advantages where he specializes in S corporations. He helps business owners understand if an S corporation election is right for their business. He also keeps current S corps in compliance with IRS regulations.
Brett received a Bachelor of Science in Business Administration from The Ohio State University. He is also a Certified Public Accountant.
When Brett is not working, he is running, biking, spending time with his wife and daughter, or trying new pizza places around Chicago.
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