If you’ve done any research on corporations, then you’ve likely encountered the terms “C corporation” and “S corporation.”
C corporations are the most common — when you form a corporation, you create a C corporation by default. Converting a C corporation to an S corporation requires additional paperwork.
The big advantage of an S corporation is that many businesses can decrease their tax burden by filing S corporation status. However, this is not an option for all corporations, as there are some strict restrictions regarding which corporations can apply for S corporation status, and which corporations need to stick with the original C corporation designation.
Are you considering applying for S corporation status? Before you do, there are several details to consider. This guide will help you understand the requirements for forming an S corporation, how to apply for one, and how these unique entities are taxed.
What Is an S Corporation?
S corporations get their name from Subchapter S of the Internal Revenue Code, which governs the formation of this entity type. On the surface, an S corporation looks very similar to a standard C corporation. S corporations have shares of stock, a board of directors, and officers to lead the business. In addition, both S corporations and C corporations are considered to be legal “individuals,” which means that they have the right to purchase and sell assets, enter into contracts, hire employees, sue or be sued, and more.
There are, however, key differences between a C corporation and an S corporation, with the primary difference being that the government places more strict requirements on the S corporation. First, an S corporation is fairly small, as it may have no more than 100 shareholders, and all of these shareholders must be U.S. citizens or residents.
Additionally, another corporation, LLC, trust, or other business entity cannot claim even partial ownership of the S corporation.
Similarly, an S corporation may issue only one type of stock, while C corporations do not share this restriction. This partially limits the potential growth of the S corporation, but depending on the unique circumstances of your business, the tax benefits may offset this downside.
Perhaps most importantly, S corporations are taxed only once on the shareholder level, and are not subject to double taxation like C corporations are. We’ll go into more detail on taxation later in this guide.
How to Apply for S Corporation Status
If you haven’t already incorporated your business, you’ll need to form a standard C corporation first by filing the articles of incorporation with your Secretary of State.
You cannot simply form an S corporation without first incorporating your business as a C corporation — only once you’ve formed a C corporation can you begin the process of applying for S corporation taxation status.
An incorporated entity can then file IRS Form 2553, also called an Election by a Small Business Corporation. This form includes some important information about your business, including your address, your tax year, when you want the S corporation status to take effect, and a legal representative who can be a contact point if there are questions about your filing.
You must file this form within two months and 15 days of the start of the fiscal year you want your new status to take effect. If you operate on a standard calendar year, then you must file by March 15. You may also file in advance for a coming year.
If the IRS accepts your form, then you will be granted S corporation status. At that point, the tax structure of your business will change from the original C corporation designation.
How S Corporations Are Taxed
The primary benefit of forming an S corporation is the taxation structure. If you operate a standard C corporation, then you will encounter what tax professionals call “double taxation,” which means that both the corporation itself and the shareholders pay taxes.
The corporation itself files a corporate tax return as an entity, at the standard corporate income tax rate of 21%. What’s left after taxes passes to the shareholders as dividends, and the shareholders then pay taxes on those dividends, so the same money is technically taxed twice.
However, S corporations are considered “pass-through” entities, so S corporations themselves do not pay taxes. Instead, the tax obligations pass to the individual shareholders, and the amount of taxes they pay depends on the size of their share. For example, let’s say an S corporation has an annual income of $1,000,000. There are ten shareholders, each with 10% of the shares.
In this case, each shareholder would report $100,000 of income on their personal income tax returns.
While the operational structure of an S corporation is quite similar to the C corporation in many important ways, there are also some crucial differences. Most importantly, the tax structure of an S corporation is usually beneficial to its owners, as in most situations the pass-through method of taxation will save you some money.
There are exceptions to this rule, however. For example, if your shareholders are high-income individuals who occupy expensive personal tax brackets, it can sometimes be a better idea to remain as a C corporation rather than registering an S corporation.
In addition, the C corporation is a much better structure if you’re looking to aggressively grow your company, especially if you want to make your corporation public rather than private, as the S corporation’s shareholder limit makes an initial public offering (IPO) unrealistic.
For many businesses, the decision comes down to whether you want to save some money on taxes, or if you want your corporation set up in a way that maximizes potential contributions from investors.
This isn’t always an easy choice to make, so if you’re having trouble deciding, you might want to contact an accountant or a business lawyer who can help you make the right decision for your business.