Unlike a traditional corporation, S corporations are pass-through entities, meaning that they elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The primary benefit of S-corps, which get their name from Subchapter S of the Internal Revenue Code, is the ability to avoid double taxation on corporate income.
Benefits of S-Corps
To determine whether an S corporation is the right legal structure for your company, it is important to understand the advantages and disadvantages. To start, an S-corp offers the same limited liability as a traditional C-corp — the personal assets of its owners are shielded from the claims of business creditors.
The owners of the business report their share of profit and loss in the company on their individual tax returns. As a result, the S-corp does not have to file its own income taxes, thereby eliminating the “double taxation” that occurs when dividend income is taxed at the corporate AND shareholder level. In addition, tax forms must be filed only once a year as opposed to quarterly for C-corps.
Income to employees and shareholders can also be distributed as either salaries or dividends (or both) from the corporation. Dividends are not subject to self-employment tax. Meanwhile, the corporation can deduct any salaries paid when calculating the amount of income that passes through to the shareholders. However, it is important to note that the Internal Revenue Service (IRS) tends to closely scrutinize the designations, and the allocation of salaries vs. dividends must be “reasonable.”
Requirements for S-Corps
The most significant disadvantage of an S-corp is that they must satisfy stringent requirements. To qualify under the Tax Code, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders:
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Due to the restrictions on shareholders and stock, not all businesses can be structured as S-corps. It is also important to note that businesses must continue to meet ALL of the above requirements in order to remain an S-corp. If you make a filing mistake, you could inadvertently become a C-corp.
Profit and loss allocations are also strictly structured. Unlike an LLC where owners can determine how income and losses are allocated, an S corporation must strictly adhere to the percentage of ownership or number of shares held. Of course, since it is a corporation, an S-corp must also meet all the traditional formalities and record keeping formalities, such as holding annual meetings.
If you have any questions, please contact us
As this article highlights, selecting the best legal structure for your business is a major decision, which requires consultation from an experienced business law attorney. If you have any questions or if you would like to discuss the matter further, please contact me, Fred Zemel, or the Scarinci Hollenbeck attorney with whom you work, at 201-806-3364.