Starting a business is exciting, but getting all the legalities in order that come with launching a business entity, can be daunting.
We take a look at S corp and business structures and how business owners can go about establishing if this entity type suits their business needs.
What is an S corp business?
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
Both C corporations and S corporations are born the same way – by filing Articles of Incorporation with the state in which the business will be located. Note that a business organized as a limited liability company can also elect to be treated as an S corporation for tax purposes.
Once a business has incorporated, it can choose to be taxed either as a C corporation or S corporation.
If the business wants to be taxed as a C corporation, nothing further needs to be done. The default tax entity for an incorporated business is the C corporation.
If the business wants to be taxed as an S corporation, Form 2553 (“Election by a Small Business Corporation”) needs to be filled out and submitted to the IRS. Filling out Form 2553 and submitting it to the IRS is also referred to as “making an S-election.”
As with any other IRS form, there is a deadline to submit Form 2553. The general deadline to submit an S-election is the due date for the S corporation’s tax return. For an S corporation with a December 31 year-end, the deadline to submit both the tax return and S-election is March 15th.
Simple business structures
If you wanted to start a business in the first half of the 20th century, you had two options:
- Form a C corporation to take advantage of liability protection but be subjected to two layers of federal tax at the corporate and individual level, or…
- Choose to be a sole proprietorship or partnership, enjoy the benefit of a single layer of taxation, but forgo the liability protection afforded C corporations.
Neither of these choices was favorable for small and family-owned businesses. In 1946, the Department of Treasury suggested the third choice of entity, one that combined the liability protection of a C corporation with the single layer of taxation from sole proprietorships or partnerships.
Understanding why the S corp entity was formed
U.S. taxpayers waited another 12 years before this suggestion of a hybrid entity actually came to fruition. In 1958, Congress and President Dwight Eisenhower created Subchapter S of the tax code. Subchapter S provided the benefit of limited liability that C corporations have while maintaining the tax benefits of sole proprietorships and partnerships.
The S corporation was created to address the specific problems faced by small businesses looking to enter markets dominated and controlled by large corporations.
There were four trade-offs, however, to using the new S corporation entity structure:
- Must be a domestic business
- Have a limitation on the number of shareholders it is allowed to have
- Have limitations on who could be a shareholder
- Can only have one class of stock
For many small businesses in the mid-20th century, these limitations were often never an issue.
Former Internal Revenue Service commissioner Don Alexander described the S corporation as “a simple structure for simple people” and simple businesses during Congressional testimony in 2006.
Starting an S corp business
The IRS states that to qualify for S corporation status, a 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).
Understanding the benefits and limitations of forming an S corp for your business is the first step in discovering if this is the entity best suited to your business and tax needs. It is advisable to consult with a CPA that understands the legalities in this regard. At Fusion, our CPAs are equipped to advise new businesses in this regard. We can also help you decide whether it is viable to change your entity structure.
This blog article is not intended to be the rendering of legal, accounting, tax advice or other professional services. Articles are based on current or proposed tax rules at the time they are written and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.
