In the United States, there are several types of corporations that individuals and businesses can form. It’s important to note that the rules and regulations governing corporations can vary from state to state, and it’s advisable to consult with a legal or tax professional to determine the most appropriate type of corporation for your specific circumstances. In this article however, we are going to focus on S Corporations. What are S Corporations and what do you need to know about them?
An S corporation, also known as an S-corp, is a type of corporation that is structured and taxed differently from a traditional C corporation. The “S” designation comes from Subchapter S of the Internal Revenue Code in the United States, which outlines the specific tax rules that apply to this type of corporation.
What are S Corporations?
An S Corporation, or S Corp, is also a separate legal entity that provides limited liability protection to shareholders. The key difference from a C Corp is that an S Corp is eligible for a special tax status under Subchapter S of the Internal Revenue Code. This means that the corporation’s income or losses are passed through to the shareholders, who report them on their individual tax returns, avoiding double taxation at the corporate level.
What is the Difference Between S Corporations and LLCs?
The main advantage of electing S corporation status is that it provides a “pass-through” taxation mechanism. This means that the S corporation itself does not pay federal income taxes. Instead, the profits and losses of the corporation are passed through to the shareholders, and they report these on their individual tax returns. S Corporation is an entity that you can elect in the United States with the IRS.
An LLC, or Limited Liability Company, is a business structure that combines the benefits of a corporation with the flexibility and simplicity of a partnership or sole proprietorship. It is a popular form of business entity in the United States, although similar structures exist in other countries as well. An LLC is only at your state level while business owners then need to decide at the federal level how they want to be taxed.
What are the Restrictions of S Corporations?
While S Corporations offer certain advantages, they also have specific restrictions and limitations that must be considered.
- Ownership Distributions
Money owners take out of the company has to be in proportion to the percentage of that ownership percentage. Meaning if you own 50% of an S Corp, 50% of the income pass through to you regardless of how much you want.
- One Class of Stock
One of the restrictions is you can only have one class of stock. Meaning no advisory shares or preferred stock in addition to common stock.
- No Foreign Shareholders
All your shareholders must be US Citizens or US Residents and is you can only have 100 shareholders.
What are the Benefits of S Corporations?
S Corporations offer several benefits that make them an attractive business structure for many small to mid-sized companies.
The main reason why people opt for an S Corporation is that it saves you on taxes by allowing you to separate your income from the business in two categories: Either a W-2 or a distribution.
- Liability Protection*
You want to talk with your attorney, but it gives you liability protection as long as it’s treated correctly.
- No Federal Tax
You have no federal tax or any double tax you need to worry about which C corporations typically do need to worry about in addition to C Corporation’s double taxation issue.
- No SALT
S Corporations can help you escape what’s called SALT (State and Local Income Tax) tax. This depends on your state.
What are the Filing Requirements for Your S Corporation?
Some of the filing requirements for an S corporation is to file a tax return every year. 1120 tax return is due on March 15th of every year or September 15 if you are on a file extension. You would need to prepare: Electing S Corporation Status, Annual Federal Income Tax Return, Shareholder Schedule K-1, and Payroll Taxes and Forms.
In addition to federal requirements, S corporations must comply with state-level filing obligations. This typically includes filing an annual state income tax return and any required state-level informational returns.
What Mistakes Do People Make with S Corporations?
While forming an S Corporation can offer significant benefits, there are also common mistakes that people can make when setting up or managing an S Corporation.
The biggest mistake we see is the failure to file annual reports. Many states require you to file annual reports. For instance, California does. This is strictly filed with the state that’s separate from your actual tax return.
Next is, they do not have payroll or they are not taking in a reasonable salary or the correct payroll amount.
And finally, they don’t have financial statements. They’re still using Excel to do everything and that can create a big problem.
To avoid these mistakes and ensure compliance with the applicable laws and regulations, it’s advisable to work closely with a qualified tax professional, attorney, or business advisor who can provide guidance and support throughout the formation and ongoing management of an S Corporation.