S corporation

An S corporation, or S-corp, is an IRS election that allows a company to be treated like an LLC for income tax purposes, that is, as a 'pass-through' entity. Instead of income taxes being owed at both the company and individual level, something known as double-taxation, the income of an S-corp is only taxed at the individual level, which means it passes through the company directly to the owners and shareholders.

One area of common confusion is what type of entity can elect S-corp status. Remember that this election is simply a tax choice, not a governance or legal structure choice. Both limited liability companies (LLCs) and corporations can choose S-corp status if they qualify under the IRS's guidelines.

26 U.S. Code Subchapter S is the section of the United States Internal Revenue Code that sets forth the requirements to be treated as an S-corp and the tax treatment of S-corps and their shareholders. To elect to be taxed under Subchapter S, an entity must:

• Be a domestic U.S. corporation or limited liability company.
• Have only one class of stock.
• Have less than 100 shareholders.
• Have shareholders who are only U.S. citizens, legal U.S. resident aliens, or not-for-profit organizations.

If taxed under Subchapter S, an S-corp is most similar to the tax status of a sole proprietorship, partnership, and LLC, with only a few slight differences.

LLCs and S-corps are very similar from a tax perspective in that both have pass-through status. There are no retained earnings or dividends of the company. The profits or losses are taxable to each owner at the end of each fiscal year.

One major difference, and the reason why owners often choose S-corp status over LLC status, is the treatment of wages paid to owners. In an LLC, the entire profit or loss of the company is treated as ordinary income and subject to what is usually a higher tax rate on the owner's tax return if the owner is also an employee of the business. For an S-corp, the owner, if employed by the business, must only be paid a reasonable salary and the rest is subject to what is usually a lower capital gains rate. So, in many instances, the S-corp may result in a lower tax burden.

Corporations are taxed as a C-corp by default, but they may elect S-corp status by filing Form 2553 with the IRS. If this election is made, the corporation will no longer be subject to 'double-taxation,' taxation at both the corporate and individual level, and instead taxes will only be payable at the individual level.

There are, however, some extra restrictions put in place with an S-corp election. An S-corp can have:

• No more than 100 shareholders.
• Only one class of shares.
• Only U.S. residents or citizens as investors.

While the total tax paid by an S-corp may be lower than a C-corp, many companies still elect to be a C-corp because it offers more flexibility in attracting investment as well as retaining and reinvesting pre-tax earnings for future growth.

Unlike a dividend from a C-corp, no tax is triggered when a distribution is made from an S-corp. While that may sound like a great deal, in reality it just means that the taxes owed on any amount distributed have already been paid because distributions are post-tax payments from a company to shareholders, while dividends are pre-tax payments.

Because of the pass-through nature of an S-corp, all profits or losses flow directly to the shareholder at the end of each tax year. That means that even if no money has been paid out through a distribution, taxes must still be paid by the shareholder every year. However, once those taxes have been paid, any distribution would then be free from any future taxes.

Unlike a C-corp, an S-corp is limited in who can invest in it.

• Only individuals, either directly or through a trust, can invest in an S-corp. No corporations, LLCs or other entities, besides 501(c)(3) nonprofits, can be investors.
• Only U.S. citizens, living in the U.S. or abroad, or legal residents can invest in an S-corp. Nonresident aliens cannot invest. Legal residents are those who are either: (i) lawfully admitted into the U.S. at any time during the past calendar year, or (ii) meet what is known as the 'Substantial Presence Test.'

The Substantial Presence Test is satisfied if an individual was physically present in the U.S. for:

• At least 31 days during the current year.
• At least 183 days total during the past three years, including the current year and the two years before the current year. You may not use all of the days you were present before the current year. You may count only one-third of the days you were present the first year before the current year and only one-sixth of the days you were present the second year before the current year. Take a look at IRS resources for clarification.

Starting an S-corp requires paying state filing fees which can range from $40 to $500, depending on the state. States also typically require annual fees to maintain a corporation's status.

Business owners must file the required documents and ensure their filing meets the many state-specific requirements for legal compliance. Rocket Lawyer can help businesses navigate the process, providing guidance and the legal know-how to make sure each filing is done quickly and correctly. Rocket Lawyer members only pay the state filing fees, while the $39.99 per month subscription takes care of the legal work. For non-members, filing an Incorporation through Rocket Lawyer costs $99.99, plus the state filing fee.

The filing fees and annual fees are not the end of the costs. When forming an S-corp, businesses will need to designate a registered agent. Registered agents are rather important as they serve as the contact point for businesses to receive legal correspondence and filings, such as lawsuits or official notices. If a business does not have a physical address in the state of incorporation (a P.O. Box does not qualify), then it can hire a professional registered agent in that state. Rocket Lawyer offers a registered agent service at $149.99 for non-members, with a 25% discount for members, to help you stay Confidently Legal™.

Unlike a C-corp, an S-corp is not allowed an unlimited number of investors. In order to maintain the 'small-business' nature of the S-corp election, only 100 investors can participate in an S-corp at any point in time. There are, however, some exceptions to the rule. Spouses and certain organizations only count as a single investor in many instances.

Not only is an S-corp limited in the number of shareholders it can have, it is also limited in the number of share classes it can have. An S-corp can have only one class of shares, so all investors are equal in right.

To be treated as an S-corp by the IRS, an LLC must first ensure it complies with all of the requirements of becoming an S-corp. That is, it must only have one share class and have less than 100 shareholders who are U.S. residents or citizens.

After ensuring compliance, the LLC must simply file Form 8832 with the IRS (compared to Form 2553 for a corporation) and choose S-corp status. Be sure to fill the form out correctly. A company can only elect a different tax status once every 60 months.

An entity converted in the way presented above would still be an LLC for state law company governance matters though. To become an S-corp in that regard, the company would have to go through the applicable conversion procedures for the state in which they are formed. They would then be a corporation and need to file Form 2553 to have S-corp status.

It should only take a few weeks to fill out and have processed the necessary paperwork to elect S-corp status, even if the company is going through the two-step process of converting to a corporation and then electing S-corp status. The forms and filings are relatively straightforward. It may, however, take months for that filing to take effect. If an election is made within the first two months and 15 days of a company's fiscal year, it will have immediate effect in that year. If made after that time, you'll have to wait until the end of the current fiscal year to enjoy your new tax election.