What is an S corporation?
An S corporation is a way of forming a business so that it pays less tax than other types of corporations. This is done by letting shareholders file their taxes using the company’s income and losses as their own. An S corporation has to file as such with the IRS, but not every business qualifies and those that do must adhere to certain rules.
As defined by Subchapter S of the tax code of Internal Revenue Service (IRS), an S corporation is a business entity that has elected to pass its corporate income, losses, credits and deductions to its shareholders to include on their tax forms. As opposed to paying federal income taxes, the shareholders report income and losses on their personal tax returns and are assessed at their individual income tax rates. The main benefit of becoming an S corporation is to avoid double taxation, which is when regular corporations are taxed at the corporate level, and then shareholders are taxed at the individual level.
An organization can only become an S corporation if all its shareholders sign and submit a copy of Form 2553, Election by a Small Business Corporation, to the IRS. It must meet the following criteria:
- It is a domestic corporation, conducting affairs in its home country.
- It has no more than 100 shareholders.
- All of its shareholders meet IRS eligibility requirements.
- It has only one class of stock, usually meaning all shares confer identical rights.
- It is not a bank, insurance company or domestic international sales corporation.
Although it may be complex and time-consuming to set up and maintain a business’s S corporation status, the substantial tax savings might outweigh the operational process. The U.S. Small Business Association points out that S corporations “require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.”
Because it’s not possible to have more than 100 shareholders, each must be entitled to identical dividends. As a result of this restriction, income and loss are governed by stock ownership, and it’s not easy to adjust the distribution to specific shareholders. Furthermore, the IRS tax code specifies that the shareholders must pay themselves “reasonable compensation,” or fair market value, as it may tax additional corporate income as wage expenses.
If you’re a shareholder at an S corporation, why not use your tax savings to finance a new car? Bankrate’s auto loan comparison tool can help.
S corporation example
George runs a small banana stand on Newport Beach. His tax attorney advises him that he and his shareholders can save a lot of money on their taxes by filing as an S corporation. George files Form 2553 by the IRS’s deadline and qualifies for S corporation status. Despite the strict records maintenance, George’s company’s shareholders are happier than ever.