Choosing a legal structure for your small business is an extremely important decision. Reason being, the structure you decide on will influence just about everything pertaining to your business – tax rates, legal protection, business liability, and more. So, take time to research the various structures that are available so you can pick one that meets your individual needs.
In this Balboa Capital blog article, we will discuss the S corporation, also referred to as an S-corp or S subchapter. This is one of the most common types of corporations in the United States. We break down what an S corporation is, what you need to form one, how it impacts taxes, and much more. We think that you will find this to be the ultimate S corporation guide.
What is an S corporation?
The history of the S corporation dates back to the late-1950s, when President Eisenhower, Congress and the Treasury Department worked together to create the small business corporation. Subchapter S of the tax code was introduced in 1958 and, much to the delight of small business owners nationwide, it eliminated the two layers of income tax at the corporate and individual level.
The removal of the double tax has encouraged small business growth and fueled our nation’s economy for many decades. An S corporation allows business owners to report their profits and losses on their personal tax returns, without being subjected to corporate tax rates. The same applies for any co-owners or shareholders that the company has. Currently there are more than 5 million S corporations in the United States, which is three times the number of C corporations.
How to form an S corporation.
There are quite a few steps to take in order to form an S corporation, but do not let that deter you from moving forward. You can opt to do this yourself, or hire a business attorney to assist you. A business attorney is an expert in these matters and can expedite your completed documents in a relatively quick manner.
In addition, a business attorney will ensure that everything is completed and filed correctly, which saves you time and eliminates the chances of having your S corporation application rejected. It is also worth noting that some states require a registered agent to review all S corporation documents, so check to see if this applies in the state that your business is located in.
Following is a list of the main things that are required when forming an S corporation:
- Business name that is not already in use in the area
- Names of the board of directors
- Issuance of common or preferred stock
- Articles of incorporation
- Names of business owners and managers
- Amount of stock shares issued
- Voting rights of owner and shareholders
- Registered agent name
- Company bylaws
- Company meeting notes/minutes
Once your S corporation has been finalized and a certificate of incorporation has been sent to your local Secretary of State office, you will need to make your company official with the IRS. To do this, visit the IRS website or contact your business attorney to get IRS form 2553, which is the Election by a Small Business Corporation form. This five-page form asks for basic information about your business along with information that you can reference in your incorporation documents.
As we mentioned earlier in this blog article, double taxation is avoided when you have an S corporation. An S corporation is a “pass-through” tax entity, which means your company’s profits will not be taxed. Rather, your profits are passed onto your company’s shareholders and taxed as personal income. Not having to pay federal taxes at the corporate level means you can save big money on your taxes.
When you and your shareholders file your individual tax returns using IRS Form 1040, you will pay taxes based on your specific share of ownership. Here is an example that explains how this works: Nicol, Kyle, Krystina and Kevin are the four owners/shareholders of a local bakery that is an S corporation. Each owner has a 25% share of the bakery. Last year, the bakery’s profits were $200,000, which means each owner had to pay taxes on $50,000 in profits.
The Qualified Business Income Deduction is another tax break that S corporations can take advantage of. This is a special IRS tax deduction that lets S corporation business owners deduct up to 20% of their income, so long as it meets specific qualification conditions. Ask your accountant or business attorney about this tax incentive, as they will be able to confirm if your company is eligible.
Your S corporation will have most of the same tax obligations as businesses with other legal structures. For example, your company needs to pay employment taxes, Social Security and Medicare taxes, unemployment taxes, and worker’s compensation taxes. Additional taxes will include state sales taxes and excise taxes, so make sure you keep accurate records of your company’s sales using a robust sales management software system. Lastly, you will have to pay property taxes if you own the physical structure of your small business, such as an office building, industrial plant, warehouse, farm, or restaurant.
Owning and operating an S corporation shows the business community that you mean business, pun intended. It helps build trust and gives your company instant credibility. Plus, it can help you attract top talent in and around your area. In addition, your vendors, manufacturers, and customers will feel more confident when doing business with you. Prior to making a decision, it is a good idea to consult with a business attorney or accountant to make sure an S corporation is the best legal structure for your small business.