Everything You Need to Know About S Corps: How They Work, Requirements, and Taxes

etting up an S Corporation (S Corp) is more complicated than setting up an LLC. However, for some companies, having an S Corp can offer significant benefits. Wondering how an S Corp works? Keep reading for a comprehensive overview of this business structure.

An S Corp is a unique type of business entity that offers the advantages of both a corporation and a partnership, with specific features designed to cater to the needs of small businesses. Some advantages of converting to S Corp are its taxation structure and limited liability. However, there are disadvantages as well, such as its complexity and accountability requirements.

How S Corps work

You'll have to follow a specific structure when setting up an S Corp. Shareholders have equity in an S Corp, and they elect directors to oversee its management and officers. S Corps have more legal requirements than LLCs or sole proprietorships. You’ll be in a better position to decide if an S Corp is the best option for you if you fully understand all of the aspects involved in running one.

Shareholders

S Corp shareholder requirements dictate that they can have a maximum of 100 shareholders, who are the legal owners of the company. Shareholders can’t be other corporations or partnerships. They hold equity in the company in the form of shares and enjoy limited liability, meaning their personal assets are protected from the company's debts and liabilities.

Directors

The board of directors in an S Corp is responsible for overseeing the company's management and making key strategic decisions. Directors are elected by the shareholders and hold regular meetings to review the company's performance, approve budgets, and set policies. Directors have an obligation to act in the best interests of the shareholders and the company.

Officers

Officers in an S Corp are responsible for managing the day-to-day operations of the company. Typical officer positions include president or CEO, vice president, treasurer, and secretary. Officers are appointed by the board of directors and carry out their responsibilities under the board's supervision. They ensure the company's compliance with federal and state regulations, manage finances, and execute the company's strategy.

Taxation

One of the main advantages of an S Corp is its favorable tax treatment. S Corps are considered "pass-through" entities for tax purposes, which avoids the double taxation experienced by C-corporations, whose profits are taxed at the corporate level and again when distributed as dividends to shareholders.

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Requirements for S Corps

S Corps' requirements govern how your business is structured, among other factors. These requirements are mandated by the IRS—and some states have additional requirements. Although S Corps are simpler than C corps from a tax perspective, they have stricter requirements regarding formation and maintenance, particularly for number and types of shareholders.

Qualifying as an S Corp

You’ll need to file Form 2553 with the Internal Revenue Service (IRS) to request S Corp status. This form must be submitted no more than two months and 15 days after the beginning of the tax year in which you want to become an S Corp.

Eligible entities

To be eligible for S Corp status, your business must be a domestic corporation or an LLC that has elected to be taxed as a corporation. Other business structures, such as partnerships and sole proprietorships, are not eligible for S Corp status. Certain types of corporations, such as financial institutions, insurance companies, and domestic international sales Corporations, are specifically excluded from S Corp eligibility.

Limitations on shareholders

S Corps have restrictions on the number and types of shareholders allowed. The maximum number of shareholders is 100, and they must be U.S. citizens or residents. Shareholders cannot be other corporations, partnerships, or certain types of trusts and estates.

Stock requirements

S Corps can only have one class of stock. All outstanding shares must have equal rights to distributions, such as dividends, and liquidation proceeds. However, differences in voting rights are allowed. For example, an S Corp can have voting and non-voting shares, provided the economic rights associated with those shares remain the same.

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Benefits of S Corps

S Corps offer several advantages that make them an attractive choice for small businesses and entrepreneurs. Key benefits include pass-through taxation, limited liability protection, and enhanced credibility. Learn more about each benefit below.

• ‍Pass-through taxation: An S Corp’s profits, losses, deductions, and credits flow through to the shareholders and are reported on their individual tax returns. Pass-through taxation allows S Corp shareholders to offset business losses against their personal income, potentially lowering their overall tax liability.‍
• Limited liability protection: Shareholders enjoy limited liability protection, which means their personal assets are separate from the company's debts and liabilities. This protection is similar to that provided to shareholders in a C corporation. By separating personal assets from business liabilities, shareholders can invest in the business and make decisions without the fear of losing their personal belongings in case the company encounters financial or legal difficulties.‍
• More credibility: An S Corp demonstrates that the company has taken formal steps to organize itself as a separate legal entity, which can inspire trust and confidence in investors and clients. It may be easier for your company to access financing, negotiate favorable contracts, and establish relationships with key stakeholders.

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S Corp taxes

How are S Corps taxed? The tax aspects of this business structure offer several advantages.

S Corp tax structure

Unlike C corporations, which are subject to double taxation, S Corps enjoy pass-through taxation. If you're wondering whether S Corps pay taxes, the S Corp itself generally does not pay federal income taxes, although it may be subject to certain state-level taxes, depending on the jurisdiction. This tax structure may result in overall tax savings for shareholders.

Filing deadlines

S Corps are required to file an annual tax return by the 15th day of the third month following the end of the tax year, typically March 15 for calendar-year taxpayers. Shareholders must also report their share of the S Corp's income, deductions, and credits.

Tax forms

The primary tax form for S Corps is Form 1120-S, the U.S. income tax return for an S Corporation. This form is used to report the company's income, deductions, and credits, as well as to provide information about the shareholders and their respective ownership interests. Shareholders receive a Schedule K-1, which shows their share of the S Corp's income, deductions, and credits, and use this information to complete their individual tax returns.

Deductions and credits

S Corps can take advantage of various deductions and credits that reduce their taxable income or tax liability. Some common deductions include operating expenses, depreciation, employee salaries, and business-related travel costs. S Corps may also be eligible for various tax credits, such as the Work Opportunity Tax Credit or the Research and Development Credit. Consult a tax professional to ensure that your S Corp is taking advantage of all the available deductions and credits.

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How to start an S Corp

Starting an S Corp involves several steps to ensure that the company is properly established and compliant with legal and tax requirements.

1. Choose a business name

Select a unique and appropriate name for your business that complies with your state's naming requirements. Typically, the name should include a corporate designator, such as "Corporation," "Incorporated," or "Limited," or an abbreviation of one.

2. File articles of incorporation

File the articles of incorporation with the secretary of state or the relevant state agency for where your business will be located. The articles of incorporation typically include the company's name, address, purpose, number of shares authorized, and the name and address of the registered agent who will receive legal documents on behalf of the company.

3. Appoint directors

Appoint the initial board of directors for your S Corp. The number of directors and their qualifications should be in accordance with your state's requirements and your company's bylaws.

4. Draft bylaws

Draft and adopt corporate bylaws, which are the rules and procedures governing the operation of your S Corp. Bylaws typically include provisions for shareholder meetings, election and removal of directors, appointment of officers, issuance of stock, and other essential aspects of corporate governance.

5. Obtain necessary permits and licenses

Acquire any required permits, licenses, or registrations at the federal, state, and local levels to operate your business legally. Depending on your industry and location, these may include a business license, sales tax permit, zoning approval, or industry-specific licenses.

6. Obtain an Employer Identification Number (EIN)

Apply for an EIN from the IRS online or by submitting Form SS-4. An EIN is a unique identifier for your business and is necessary for tax reporting, employee payroll, and opening a bank account in your company's name.

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Maintaining your S Corp status

Once you’ve formed an S Corp, you’ll need to maintain compliance with legal and tax requirements. The key responsibilities and actions involved are good business practices that you’d likely do anyway. However, there may be a few extra steps involved in ensuring proper form and documentation.

Annual meetings

S Corps are required to hold annual meetings for both shareholders and directors. Shareholder meetings typically involve the election of directors and any other matters requiring shareholder approval, such as major business decisions or amendments to the company's bylaws. Director meetings involve reviewing the company's performance, approving budgets, and making key strategic decisions. You must give proper notice of meetings and keep a record of the minutes with the company's records.

Recordkeeping

S Corps must maintain accurate and up-to-date records, including financial statements, tax filings, meeting minutes, and other essential documents. Accurate recordkeeping not only helps to ensure compliance with legal requirements but also serves as a valuable resource for making informed business decisions. Opening a business checking account with Novo can help you keep your financial records organized to make recordkeeping easier. Key records that should be maintained include:

• Articles of incorporation and any amendments
• Corporate bylaws and any amendments
• Minutes of shareholder and director meetings
• Stock ledger and records of stock issuances and transfers
• Financial statements and accounting records
• Tax filings and supporting documentation
• Business permits, licenses, and registrations

Filing taxes

To maintain S Corp status, you must file the necessary tax forms each year. Shareholders must also report their share of the S Corp's income, deductions, and credits on Schedule K-1. The information from Schedule K-1 is then reported on the shareholders' individual tax returns.

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Next steps in starting an S Corp

S Corps offer a unique and advantageous business structure that combines the benefits of both corporations and partnerships, including pass-through taxation, limited liability protection, and enhanced credibility.

Every business's circumstances are unique, so you should seek professional assistance from a tax adviser, attorney, or accountant to ensure compliance with legal and tax requirements and make the most of the S Corp structure. For more information, check out the U.S. Small Business Administration (SBA) and SCORE, both of which offer support, guidance, and educational materials for entrepreneurs.

When you're ready, Novo has partnered with LegalZoom to help you launch your S Corp.

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