How to Form an S-Corporation
S-Corporations (“S-Corps”) are “Small Business Corporations” which are defined and governed by subsection S of Chapter 1 of the Internal Revenue Code.
An S-Corp is not a legal entity but is a federal tax designation. The S-Corp designation allows the owners of the company to retain the limited liability protection of their initial corporate or LLC structure while also allowing for potential tax savings. An S-Corp does not pay federal income tax at the corporate level (avoiding the double taxation C-Corps are subject to), instead the shareholders report the flow through of income and losses on their personal tax returns.
In an S-Corp, owners pay themselves a reasonable salary (from which FICA and payroll taxes are withheld), then the remaining corporate income is paid to the owners through distributions, which are taxed at a lower rate. Unlike an LLC, where the owners pay self-employment tax, the owners of an S-Corp are not considered to be self-employed, so they don’t pay self-employment tax.
While there may be a tax benefit to being designated as an S-Corp, please note that S-Corps are subject to any applicable employment taxes, property taxes, state sales, excise and franchise taxes, state income taxes, and gross receipts taxes.
Qualifying as an S-Corp
Not every entity can be designated as an S-Corp. S-Corps have strict requirements that must be met by the shareholders, if any of these requirements are not met at any time then the S-Corp status is lost.
To qualify for an S-Corp, the corporation must meet the following requirements:
Be a domestic corporation
Have only permissible shareholders:
- May be individuals, certain trusts, and estates
- May not be partnerships or corporations
- Must be a US citizen or resident
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (certain financial institutions, insurance companies, and domestic international sales corporations).
Profits and losses must be distributed to the shareholders in proportion to the shareholder's interest.
How to Become an S-Corp
Form either a corporation or an LLC in your chosen state by filing the appropriate forms.
Meet the requirements of an S-Corp (see above).
Submit Form 2553 Election by a Small Business Corporation signed by all Shareholders. When you elect S-corporation taxation (by filing Form 2553), the election takes effect on January 1 of the following year, with a few exceptions:
- § If you file Form 2553 by March 15 of a given year, you can choose to have the election be effective as of January 1 of that year.
- § In the year your business is formed, if you file Form 2553 within the first two months and fifteen days of the business’s existence, you can choose to have the election be effective for the business’s first year.
Termination of S-Corp Designation
If at any time your corporation or LLC no longer meets all of the requirements for S-Corp designation (see above), your S-Corp status will be terminated automatically. You may also elect to terminate your S-Corp designation at any time if you have the consent of shareholders owning more than 50% of the shares of the business. If your S-Corp designation is terminated, you will have to wait five years before you can elect another S-Corp designation without the IRS’s consent.
Upon the termination of the S-Corp designation, the business will be taxed as it would have been before the designation. Thus, a corporation will be taxed as a C-Corp and an LLC will be taxed as either a sole proprietorship or a partnership depending on the number of members.
Determining which legal structure and tax designation is appropriate for your business can have major legal and financial implications. While this article strives to provide detail on S-Corps, we highly recommend that you speak with your business attorney and accountant before determining which entity and designation is right for you.
Should you have any questions in relation to structuring your business please contact me at firstname.lastname@example.org.
 C-Corporations are subject to tax at the corporate level and then as the income is distributed to shareholders, the shareholders are taxed, thus C-corporations are often referred to as being subject to double taxation, i.e. at the corporate and individual level.