So, what’s an S-Corp? Does it make sense for your company? Do you need an advanced accounting degree to figure it out?
First off, an S-Corp isn’t a different kind of entity than a typical corporation (the C-Corp), it’s just a tax election. That is, structure, operation, even legal formation documents could be exactly the same regardless of which type of corporation you are (though you’d probably want to tailor your Articles of Organization, but that’s a different post). The point is, legally, both entities are exactly the same. When you become an S-Corp, that just means that you meet certain qualifications and make a filing with the IRS so that you’re taxed differently.
As such, before you can understand what makes an S-Corp special, you have to understand how a regular C-Corp is taxed. You have to understand the concept of double taxation.
When a C-Corp makes money, it files its tax return and the IRS (and the state department of revenue) will make it pay taxes on the money it takes in. That’s the first level of taxation. Then, when the corporation is profitable and makes distributions to shareholders, those distributions are taxed again. The shareholders, then, are subject to two levels of tax before they ever get any money out of the business.
The big benefit of the S-Corp is that it cuts out a level of taxation. The way this is accomplished is by cutting out the corporate tax. Instead, all corporate profits and losses “pass-through” to the shareholders. By way of a simplified example, if I own 10% of the shares of Corporation X, and that company makes $100,000.00 in a year, then the corporation pays no tax and I pay taxes on my 10% share of the profits and losses ($100,000.00) on my own income tax return. Since that income is typically taxed as a distribution, the tax rate itself is favorable as well.
Sounds great, what’s the catch? There are two. First, since the tax rate on distributions is a lot lower than the tax rate on employment income, any self-respecting entrepreneur would necessarily not pay themselves a salary and take all their money out of the company on a distribution. The IRS is on to you, and as such, any shareholder who also performs work for the S-Corp has to take a “reasonable” payment for work done as employment income, which is taxed at a higher rate. If you don’t, you run the risk of the IRS reclassifying your distribution income as employment income, and getting served with a big tax bill complete with penalties.
The second catch is that as an S-Corp you’ll be subject to more restrictions on your makeup and structure. Via the IRS, you must:
- Be a domestic corporation
- Have only allowable shareholders
- including individuals, certain trust, and estates and
- may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have one class of stock
- Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
In other words, you’re generally limited to a smaller number of shareholders, who generally are going to be individuals, and you can only have one class of stock. This means that an S-Corp is typically not going to be a viable option for companies that have already or are looking to shortly receive venture or angel investment (since that investor is typically a corporation and will require a separate, preferred class of stock). But if those restrictions are no big deal for you, and they’re not for many small businesses, then an S-Corp can be a great way to keep more of the money your business taxes in.
Massachusetts S Corp Considerations
The entire above discussion pertains to federal corporate tax, but it’s important not to forget about state corporate tax. Naturally, every state deals with S-Corps a little differently, so it’s important to talk with someone knowledgable in your jurisdiction to figure out tax implications in your state. In Massachusetts, the Commonwealth will recognize S-Corps just like the IRS, but the corporation is still going to owe a minimum tax payment of $456.00 each year, and will owe taxes on any amount they’re taxed on federally, and any amount they earn over $6 million.
So how does one go about creating an S-Corp? It’s pretty easy actually. First, you need to form a corporation under the laws of your (domestic) jurisdiction. Once you’ve done so, you must fill out and have each shareholder sign IRS Form 2553 and submit it to the IRS no later than two months and fifteen days after the start of the tax year. In Massachusetts, there’s no separate election that must be filed at the start of the tax year, but the corporation must file Form 355S along with a Schedule S and Schedules SK-1 with its return each year.
So that’s an S-Corp, no accounting degree required. For more info about S-Corps (or any other issue facing small businesses), check out the Small Business Administration website.
How are you using or thinking about using your S-Corp? Post about it in the comments.