Are there a lot of formalities in an S-Corp?

S-Corporation

S corporation is very popular among solopreneurs and professionals.

Most business owners sort of "graduate" from an LLC to an S corp over a period of time.

In this guide, we will understand what exactly an S-Corp is and its benefits

At the end of this guide, you'll be able to decide whether an S-Corp is right for you or not.

Let's dive right in.

Definition

What is an S-Corporation?

S-Corporation, aka S subchapter is a tax classification made by companies that allow income & losses to be passed through to the shareholders.

It is a tax classification and not a new business entity.

It is just an election that can be made by one of the existing business entities: LLC, C corporation or partnership.

If you meet the requirements set by the IRS and file Form 2553, your business entity can be elected as an S-corp.

It is sort of like a combination of partnership and a corporation: it has flow through income like a partnership and hires shareholders as employees like a corporation.

Now, why would anyone want to be an S-corp?

A couple of important reasons.

Lower taxes.
No double taxation (leads to lower taxes, again)

Since all the incomes & losses are passed on to the shareholders, federal income tax is levied only once at the individual level.

If you are making quite a bit of net income ($60k+), then you'll start getting the tax benefits of being an S-corp. If your annual income is lower than that, you may not get the most out of it.

Ownership

Can anyone own an S-corp?

LLC, partnership and C corporation are the types of entities that can elect to be an S-Corp.

Owners of these entities will become the shareholders of the S-Corp after election.

They are more than just shareholders. IRS requires the S-Corp to hire shareholders as employees and pay them salaries.

So, the shareholders get 2 types of income from an S-Corp:

01Salary, from being an employee
02Distribution, from being a shareholder

Because of this dual nature, not every LLC/Partnership/C corp can be elected to be an S-Corp.

There are some eligibility requirements to be an S-Corp. They are:

Have a maximum of 100 shareholders.
All shareholders/members must be US citizens or legal residents.
Issue only once class of stock.
Shareholders have to be individuals — not LLCs or corporations.

For non-residents

Entities owned by non residents cannot elect to be an S-Corp. US residency is one of the conditions of IRS to be an S-Corp

Now, that we have seen who can own an S-Corp, let's understand why one should consider an S corp.

Advantages

What's so special about an S-corp?

Limited liability

Limited liability protects shareholders' personal assets from debts and liabilities of the S-corp, in case of a lawsuit or huge debts. This means, the shareholders are not personally responsible for the corporation's debts and obligations.

No double taxation

Business income from the S corp is passed through to the shareholders. It is not taxed at the entity level. It is only taxed at the individual level. Hence there's no double taxation.

Save on self-employment tax

Shareholders earn Distribution & Salary from the corporation. They pay income tax & self employment taxes on the salary, whereas only income tax on the distribution. Because of just 1 tax on distribution income, the overall tax liability also decreases.

Deduction of operating losses

If your S corp incurs some losses, shareholders can deduct some of it from their personal tax return.

Disadvantages

When is S-corp not right for me?

More formalities

Because of the additional requirement of hiring shareholders as employees, you have to withhold taxes, enrol in state worker's compensation, file additional forms and other stuff which are kinda expensive.

Expensive to reinvest

If you plan to reinvest most of your earnings, then you'll end up paying higher taxes as compared to C-Corp or LLC. But, if you wanna take the money out of your company and pay yourself, S-Corp is better.

Limited fund raising

In an S-Corp, you can only issue 1 class of stock, have only individuals as shareholders and a maximum of 100 shareholders. These restrict the potential of attracting capital from venture capitalists or through an IPO. Also an S-Corp cannot be acquired by another entity either.

Closely watched by IRS

Compared to other entities, IRS closely watches S-Corp. Since many try to evade taxes by having unreasonably low or zero salary, S-Corp taxes are heavily scrutinised.

Taxes

What are my tax obligations?

S-Corp, at the entity level, pays 2 types of taxes: Payroll tax and franchise tax.

Individual shareholder pays another 2 types of taxes: Self-employment tax and ordinary income tax.

Taxes are paid to the federal and state governments.

Depending on the state of incorporation, total assets and issued shares, tax treatments can vary.

What the S-Corp pays:

Payroll tax

Social security tax, medicare taxes and unemployment insurance are collectively referred to as 'payroll taxes'. S-Corp pays this when there are employees.

Half of this tax amount is collected from the employee's paycheck. And the other half is contributed by the company.

Form 941, Employer's Quarterly Federal Tax Return is filed to report income taxes, Social Security tax, or Medicare tax withheld from employee's paychecks.

Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return is filed as well.

Franchise & Excise tax

Most states charge an annual fee, often called as "franchise taxes", "renewal fees" or "annual registration fees". This could be fixed, or variable depending on the S-Corp’s authorized shares and assets. States have different methods of calculating franchise taxes. Some states don't charge franchise tax at all.

In addition to this franchise taxes, almost all states have a small annual report fee that has to be paid while filing a mandatory annual report.

Also, excise taxes are typically imposed on manufacturers and retailers of goods and services. Not very common, however still important to many types of businesses.

Note

Take the time to understand how each state calculates their franchise taxes. If you don't understand how your chosen state calculates it, you could end up with a tax amount in hundreds of thousands dollars.

In addition to this, some states like California also charge state income tax.

Though S corporations don't pay any federal income tax, they have to file Form 1120-S(US Corporation Income Tax Return) annually. It reports the income, losses, dividends of the shareholders. Form 1120-S is simpler than the tax forms for a corporation.

And for every shareholder Schedule K-1 is prepared, which is attached to Form 1120-S. It identifies the percentage of shares owned by each shareholder.

What the shareholder pays:

Personal Income tax

As an individual, shareholders have to file Form 1040 to report their individual incomes and losses.

This is paid on incomes from both Distribution and Salary.

Self Employment tax

Self employment tax is paid on shareholder's salary.

It is not paid on their distribution income, though. That's where the tax savings is.o, excise taxes are typically imposed on manufacturers and retailers of goods and services. Not very common, however still important to many types of businesses.

When to pay taxes?

Taxes are not to be paid once at the end of the year.

Sorry to break it to you. That’s not how it works.

You will have to estimate the annual income for each shareholder ahead of time and split it into 4 quarterly payments to the IRS. This is referred to as estimated taxes.

IRS is pretty serious about this.

They charge a penalty if you fail to pay an instalment or pay it late.

So, keep this in mind.

Use Form 1040-ES to figure and pay your estimated tax.

Tax rates

Below are some of the common tax rates applicable to an S-Corp.

Some of these numbers will vary depending on your exact business situation.

Take this only as an approximate figure.

32-37%

Top 3 personal income tax rates

15.3%

Self employment tax

6.2%

Employer portion for social security tax

1.45%

Employer portion for medicare tax

Total FUTA tax including state credit

Pay Yourself

How do I pay myself from an S-Corp?

Alright, it's time to pay yourself.

There are 2 ways of paying yourself as a shareholder in an S-corp: Salary and Distribution.

There are some tax benefits associated with distribution income and that's one of the key reasons for choosing a S-Corp.

Let's see them in detail.

Salary

Unlike an LLC, it is mandatory for shareholders to be hired as employees in an S-Corp.

This means, shareholders get a salary.

This salary is considered as an expense for the S-Corp. When it is paid to the shareholder, this is subject to both income tax and self employment taxes. On the other hand, distributions is subject to only income tax.

Because of this, people try to reduce their tax liability by keeping the salary unreasonably low.

This is dangerous. Because, IRS requires you to give yourself a 'reasonable' salary. They have not clearly defined what is 'reasonable'. But think of it like the salary you would have given to another person who were to do your job.

And if you're found guilty of not paying a 'reasonable' salary, you could get fines and backtaxes.

Distribution

After salary deduction, earnings from the S corp is passed through to the shareholders as distributions.

It is not taxed at the entity level, but it is subject to personal income tax at the shareholder level. No self employment tax here.

Costs

How much does an S-Corp cost?

There are different types of costs involved in an S corp.

And it depends on a lot of factors: state of formation, nature of business, etc.

Below are some of the ones you could incur:

One time

Formation/Incorporation fee for the State

$90 - $100

Reserve business name

$75

Annually

Registered agent costs

$100 - $300

State franchise tax

$50 - $800

State annual report fees

$50 - $75

Quarterly

Individual shareholder Income tax

21 - 37%

Payroll tax - employer contribution

7 - 10%

State Income tax

0 - 1.3%

Service charges

Lawyer

$100 - $500/hour

CPA

$100 - $500/hour

Hiring

Can I hire employees in an S corporation?

You can definitely hire employees in an S-corp.

S-Corp is simple enough for you to hire employees and complex enough to protect you in case of employee lawsuits.

Hiring comes with a few responsibilities, though.

Have to withhold tax from the employee's wages for Social Security, Medicare and unemployment insurance, deposit it with the IRS and state agencies.
Have to file Form W-2 for each employee(including shareholders) with the IRS.
Depending on the state you're in, state and local authorities have to be notified about the new hires.

State of Formation

Which state should I form my S-corp in?

Let me repeat.

S corp is not a new business entity. It is just a tax election made by an LLC/Partnership/C Corp.

So, you technically can't "form" an S-corp.

Wherever your LLC/partnership/corporation is registered, that's your state of formation.

As a rule of thumb, if you have a physical office or an employee located in the US, pick that state. For example, if you have a boutique shop in California, where you sell your goods, pick California.

If you have an e-commerce store that you manage online, but you stay in Texas, pick Texas.

Why should you pick the state where you have a physical store?

Because if you're doing business in a state outside the state of formation, you'll have to file a foreign qualification in the "outside" state, in addition to your existing state of formation.

For example, if you are incorporated in Delaware, but end up having a store in California, you'll have to register your corporation as a 'foreign corporation' in California, in addition to Delaware.

That’s 2 states. 2 times the cost.

For non-residents

If you're planning on raising venture capital or get acquired, you may want to consider incorporating in Delaware even if you're not doing business in Delaware. This is because Delaware is very business friendly and the legal system is one of the most advanced. Most investors "require" companies to be a Delaware corporation.

Converting S-Corp

Is S-corp the best choice for me?

Once your LLC or corporation is up and running, you will come across situations where you may want to change your tax classification to be an S-Corp.

You may want to avoid double taxation or save on self-employment taxes.

On the other hand, you may even want to convert from S-Corp back to an LLC.

Whatever your reason is, let us see some of the common conversion.

Why should you convert?

As you start generating more income, you might want to save on the self employment tax. You could elect to be an S-corp and pay yourself a salary and reduce your tax expenses.

How to?

Meet the requirements of IRS to be an S-corp

File Form 2553.

Why should you convert?

If you find the paperwork to be cumbersome or if you want to be treated as a partnership or if you're bringing on a non-resident member, you can convert to an LLC. There are tax consequences for the shareholders as the conversion leads to liquidation of the S-corp's assets.

How to?

Consent from majority shareholders

Filing forms with Secretary of State

Why should you convert?

C corp is subject to double taxation, whereas S corp is not. You also have a few tax benefits in an S corp.

How to?

Meet the requirements of IRS to be an S-corp

File Form 2553.

Why should you convert?

In an S-corp, you can issue only one class of stock and the shareholders cannot be corporations or trusts. This makes it hard to raise venture capital or go for an IPO.

How to?

Consent from majority shareholders

No official IRS form. You can file a written statement with the appropriate IRS service center.

Comparisons

What are the differences between S-Corp and other entities?

Maybe, S- Corp isn't the best entity for you. Maybe it is a C-Corp. Maybe it is an LLC.

Only way to find out is to directly compare them all.

S-Corp vs C-Corp

C-corp is a business entity, whereas S-corp is just a tax election. Raising outside capital from investors is much more convenient for a C-corp. On the other hand, S-corp comes with the headache of double taxation.

Read in detail

S-Corp vs C-Corp

S-Corp vs LLC

LLC is a legal entity, whereas S-corp is just a tax election. S-corp offers more tax savings, even though there is no double taxation for both.

Read in detail

S-Corp vs LLC

FAQ

S-Corp requires slightly more paperwork than LLC due to its hiring requirements. However, most of them are one-time and may not require a lot of your time. There are a couple of annual reports to be filed with the federal and state agencies. You will also have to conduct board meetings and record minutes for it.